First of all let’s see how Fibonacci levels are built, it is very fascinating if you like math (who doesn’t?!).
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144…
This is Fibonacci series. The series starts with 2 numbers, 0 and 1, then the third number is built adding the first 2 numbers: 0+1 = 1; the fourth number is the result of the second and the third: 1+1 = 2 and so on.
After the first few numbers in the sequence, if you measure the ratio of any number to the succeeding higher number, you get 0.618. For example, 55 divided by 89 equals 0.618.
If you measure the ratio between alternate numbers you get 0.382. For example, 34 divided by 89 = 0.382
Now I’m not going any further, but with these ratios you build the Fibonacci retracement levels: 0.236, 0.382, 0.500, 0.618, 0.764
Keep in mind this first part because I’m going to talk a few minutes about the trend.
What is a trend? The trend is simply the direction of the market, so which way the currency pair is moving. But when you have a look at the chart, the first thing that you notice is that there is no straight line to help you to identify any direction. You never see something like this:
But you can see something like this:
This is a clear example of an uptrend.
As you can see the price goes up, then it goes back a bit. It goes up again and it goes back a bit more. This “going back a bit” is called reversal.
Traders have always tried to find the answer to a question: “how long will the bearish reversal last during the uptrend?” (or of course “how long will the bullish reversal last during the downtrend?”).
Fibonacci is one of the most famous tool used by traders to try to answer this question.
Let’s start (START?! I know I’m writing a lot today, markets are not moving and I don’t know what to do) with an example of Fibonacci retracement.
This is GBP/USD on a H4 chart.
The price goes up but then seems to come back. You can draw Fibonacci retracements connecting the low with the high of the up movement.
You will have all the levels that we have discussed above: 0.236, 0.382, 0.500, 0.618, 0.764.
What do these levels tell you? If the price reaches 0.236 level, it means that the price went back of 23.6% of the original movement. Let me explain it better with a real example.
The price goes up of 100 pips, then it goes back and touches the 0.236 level of Fibonacci retracement. It means that it went back of 23.6% of the original price movement, that was 100 pips. So the price went down by 23.6 pips after going up by 100 pips.
In the GBP/USD chart that you can see above, the price went up of about 300 pips, then it came back for a total of 185 pips, touching the 61.8 level of Fibonacci retracements, and then it went up again.
Traders look at Fibonacci levels because they want to enter the trade at the best price available on the market (of course!). So when there’s a reversal, they study the price action on Fibonacci levels to check if it can be a good opportunity to enter the trade.
My considerations about Fibonacci:
- It is said that Fibonacci retracement is a self-fulfilling indicator, since so many traders watch these same levels and place buy and sell orders on them. When many traders buy at the same level, they can increase the demand for that currency pair and so the price increases too. I’ve always been a bit skeptical about this. Forex trading has $4.1 trillion transactions every day on average, how can our $1000s trades influence the market? With this I don’t want to diminish the utility of Fibonacci levels as reversal calculator, but I want to express my skepticism when I read “Fibonacci retracement is a self-fulfilling indicator”;
- Fibonacci assumes that trends will continue, with this assumption I am quite sure that I can give 6–7 numbers like 15, 25, 35, 45, 55, 65 and succeed as well. Price will stop in one of those areas before going on following the trend again.
- Fibonacci can be very useful to study where, statistically, reversals stop. For example, it was commonly believed the .618 retracement would contain countertrend swings in a strongly trending market. That level is now routinely violated, with the 0.764 retracement offering strong support or resistance, depending on the direction of the primary trend. Traders and market timers have adapted to this slow evolution, altering strategies to accommodate a higher frequency of whipsaws and violations.
I have a huge respect for Mr. Fibonacci and we have a lot of things in common. He was Italian and I am also half Italian; he was a very talented mathematician and… well, I can solve linear equations.
Good luck with Fibo 😉