If you’re looking to improve your forex trading skills, Fibonacci retracements can be a valuable tool. This technical analysis technique uses ratios derived from the Fibonacci sequence to identify potential reversal points in a market trend. This article will cover the basics of using Fibonacci retracements in forex trading. So if you’re ready to explore more about Fibonacci retracements, keep reading.
What Fibonacci retracements are, and how they’re calculated
A Fibonacci retracement is made up of a chain of numbers that starts with zero and one, and each subsequent amount in the sequence is the sum of the previous two amounts. So the sequence looks like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc. The ratios derived from this sequence – 23.6%, 38.2%, 50%, 61.8% – are known as Fibonacci levels.
They are created by taking two extreme points on a chart (typically a peak and a trough) and dividing the vertical distance between them by the key Fibonacci ratios of 23.6% and 38.2%, 50%, 61.8%. It will create horizontal lines that can be used to identify potential support and resistance levels.
For example, let’s say we’re looking at a chart of the EUR/USD currency pair, and we see a clear downtrend. We identify the most recent peak and trough and then calculate the Fibonacci retracement levels. We see that the 38.2% Fibonacci level aligns with a previous area of support, so we enter a short trade at this level. Unfortunately, the price continues to fall, and our trade is stopped for a loss.
However, we see that price finds support at the 61.8% Fibonacci level and starts to rebound. We re-enter our short trade at this level, and this time we can ride the market lower and make a profit at our target price.
How to use Fibonacci retracements in forex trading
The most common way to use Fibonacci retracements is to identify potential support and resistance levels. As we saw in the previous example, Fibonacci levels often align with previous support and resistance areas, making them excellent potential entry and exit points for trades.
Another way to use Fibonacci retracements is to identify market turning points. It can be done by looking for candlestick patterns or other technical indicators that form at the Fibonacci levels. For example, a bullish reversal candlestick pattern formed at the 61.8% Fibonacci level in the EUR/USD chart above signaled that the downtrend was coming to an end and that prices were about to start moving higher.
It’s also worth noting that Fibonacci retracements can be used in any time frame so they can be helpful for short-term traders and long-term investors.
The different types of Fibonacci retracements
There are two types of Fibonacci retracements that you should be aware of:
The first type is a plain Fibonacci retracement, created by taking two extreme points on a chart and dividing the vertical space between them by the key Fibonacci ratios.
The second type is an extended Fibonacci retracement, created by taking three extreme points on a chart and dividing the vertical space between them by the key Fibonacci ratios.
Extended Fibonacci retracements are typically used to identify potential targets for reversal trades. For example, suppose we see a market trend that has been extending lower for some time. In that case, we might use an extended Fibonacci retracement to identify a potential target area for a long trade.
Tips for using Fibonacci retracements effectively in your trading strategy
Regarding Fibonacci retracements, many traders are self-taught and apply their techniques to find critical support and resistance levels. However, if you’re starting, then we recommend that you follow these tips:
Look for Fibonacci levels that align with previous areas of support and resistance. These are typically the most important Fibonacci levels and should be given more weight in your analysis.
Use Fibonacci retracements on all time frames. Fibonacci retracements can be used in any time frame, so make sure you look at multiple time frames when applying this tool to your charts.
Be patient and wait for confirmation before entering a trade. As we’ve mentioned, Fibonacci levels are not exact, and it’s often best to wait for a candlestick pattern or other technical indicator to form before entering a trade. It will help confirm that a reversal is indeed taking place.
Take profit at Fibonacci levels or wait for a breakout. When using Fibonacci retracements to identify potential reversals, many traders will take profit at the next Fibonacci level or wait for prices to break out above or below these levels before entering a trade.