How to Trade The Fibonacci Sequence

The Fibonacci sequence, which is the basis for the Fibonacci levels in Forex, was discovered by Leonardo de Pisa, an Italian mathematician. Nicknamed Fibonacci, Leonardo de Pisa was born in the year 1170 in the Italian city of Pisa. He traveled a lot with his father and lived with him in Bejaia, a Mediterranean port in northern Algeria, where he studied mathematics.

During his extensive travels, the young Leonardo learned the benefits of the Hindu-Arabic numeral system, and on returning to Italy in 1202, he documented his discovery in his famous work — ‘Liber Abaci’, which popularized the Hindu-Arabic numeral system in Europe.

 

In the book, he described a sequence of numerical numbers now known as the Fibonacci sequence of numbers.

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The Fibonacci sequence of numbers is a numerical series documented in Leonardo’s ‘Liber Abaci’. In the sequence, after 0 and 1, every number is the sum of the two numbers before it. Thus, the Fibonacci sequence looks something like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, and so on.

 

As you can see, the sequence can extend to infinity. Looking at the numbers, you will observe that every next number is approximately 1.618 times larger than the preceding number — or the other way round, each number is 0.618 of the number following it. For example, if you divide 55 by 34, you will get 1.618, and if you divide 34 by 55, you will get 0.618.

With the exception of the first few numbers, dividing a number in a number in the sequence with the preceding number gives a fairly consistent ratio. From the example above, the ratio is 1.618, and its inverse is 0.618. This value, 1.618, is known as Phi or the golden ratio — it occurs in several aspects of life.

Apart from the golden ratio and its inverse, other ratios can be derived from the Fibonacci number sequence. For instance, 0.382 can be gotten from dividing a number by the number two places to the right — say, 89 divided by 233. Another important ratio is 0.236, which is derived from dividing a number by the number three places from the right — say, 34 divided by 144.

 

While you may find other ratios from the Fibonacci number sequence, when it comes to forex trading, the most important Fibonacci ratios are these four: 0.236, 0.382, 0.618, and 1.618.

Apart from its significance in Forex technical analysis and the rest of the financial world, the golden ratio (1.618), or its inverse (0.618), has been shown to appear frequently in every aspect of life, from biology and the natural world to fine arts and architecture, to all parts of the universe (even patterns of solar systems).

For instance, the ratio has been observed in the Parthenon, tree branches, sunflowers, rose petals, mollusk shells, Leonardo da Vinci’s Mona Lisa, human faces, spiral galaxies of outer space, and the ancient Greek vases.

 

One of the most famous examples of the golden ratio can be seen in the nautilus shell. The nautilus shell expands in a logarithmic spiral, which follows the Fibonacci ratio. Connecting the arcs with squares, or Fibonacci tiling, it becomes obvious that the sizes of the squares follow the golden ratio.

Obviously, one of the areas where the Fibonacci ratios are often applied is in Forex technical analysis, where they are used to mark price retracement and extension or expansion levels — the Fibonacci levels. Converting the ratios to percent gives the Fibonacci levels.

So, the 0.236 ratio becomes the 23.6 % Fibonacci level; the 0.382 ratio becomes the 38.2% Fibonacci level; the 0.618 ratio becomes the 61.8% Fibonacci level; and the 1.618 ratio becomes the 161.8% Fibonacci level.

Apart from the four levels — 23.6 %, 38.2%, 61.8%, and 161.8% — other levels are derived from different combinations of the four basic ratios. For example, 100% level is gotten from adding 38.2% and 61.8%; 123.6% is gotten from 100 and 23.6; 138.2% is gotten from 100 and 38.2; while 261.8% is gotten by adding 100 and 161.8.

 

Although 0.5 is not usually seen as a Fibonacci ratio — not technically true since 1 and 2 are in the Fibonacci sequence and 1 divided by 2 is 0.5 — the 50% level is added in the Fibonacci tools because it is a significant level in the Dow Theory.

Almost all trading and charting platforms, if not all, have some or all the Fibonacci measurement tools, which traders use to mark important price levels or timelines. There are several Fibonacci tools you can encounter on these platforms, such as:

·        Fibonacci retracement/extension

·        Fibonacci expansion

·        Fibonacci fans

·        Fibonacci arcs

·        Fibonacci channels

·        Fibonacci time zones

 

But Fibonacci retracement/extension and Fibonacci expansion are the most widely used Fibonacci tools.

Depending on the levels added, this tool can have two parts: the retracement part and the extension part. The retracement part consists of horizontal lines that indicate the 23.6%, 38.2%, 50%, and 61.8% retracement levels from the preceding price swing high or swing low, while the extension part consists of the -23.6%, -38.2%, -61.8%, -100%, -161.8% extension levels from the preceding swing high or low.

 

Obviously, the retracement levels show the percentage of the previous swing the price can pull back before it starts moving again in the trend direction. The extension levels, on the other hand, show the percentage by which the price is extending beyond the preceding swing’s high or low.

You apply this too in a trending market when a pullback starts. To pick this tool from the MT4 platform, click on Insert and click on Fibonacci from the dropbox. Then, click on Retracement. On the chart, place the first point on the price swing high/low, from where you want to start your measurement, and drag it to the most recent swing low/high before the current pullback.

 

So, in an uptrend, you start from a swing low and drag to the most recent swing high, while in a downtrend — as you can see in the EUR/USD chart below — you start from a swing high and drag to the most recent low. In the chart below, the pullback has reached the 50% retracement level.

A screenshot portraying a 50% Fibonacci retracement.

The expansion tool functions just like the extension levels, in the retracement tool in that it projects where the price can get to after a pullback. However, unlike the extensions levels that project how far the price can extend from the preceding swing low/high, the expansion tool measures the price expansion from the pullback’s high/low.

Just like the retracement tool, it is used in a trending market. You apply the expansion tool when the pullback has completed and the price has resumed in the trend direction. The tool has three points that must be fixed at the starting swing high/low, the recent swing low/high, and the current pullback’s high/low, as the case may be. To get the tool in an MT4 platform, go to Insert > Fibonacci > Expansion.

 

Take a look at the EUR/USD chart below. The price is in a downtrend, so the three points of the expansion tool are attached at the starting swing high, a swing low, and the highest point of the pullback. We didn’t use the most recent swings and the current pullback, because we aren’t sure the pullback is over and also to show the reactions at the expansion levels. Note the reactions at 50%, 78%, and almost 100% expansion levels.

A screenshot portraying a Fibonacci retracement.

There are other Fibonacci tools, such as the Fibonacci fan, arcs, spirals, channels, and time zones. All the tools are based on the Fibonacci ratios. The Fibonacci fan, spirals, and arcs are used to project spatial price points and levels, while the Fibonacci channels project price direction. With the Fibonacci time zones, you may be able to time the market cycles.

The Retracement Levels

You can use the retracement levels to anticipate where a pullback may end since you can see the levels before the price gets there. Depending on the direction of the trend, the 38.2%, 50%, and 61.8% retracement levels can act like a support or resistance level where the price gets to and reverses.

In an uptrend, the retracement levels can serve as support levels where a pullback may reverse, while in a downtrend, they can serve as resistance levels. Thus, they can be used to estimate where to place stop loss orders. Some traders also use them in breakout trading.

 

From the picture, you can see the price is at the 50% level and may reverse from there to continue the downtrend. 

A screenshot portraying a 50% Fibonacci retracement.

The Extension and Expansion Levels

These levels also serve as potential support or resistance levels, depending on the direction of the trend. In an uptrend, they serve as potential resistance levels, and in a downtrend, they may become support levels. So, you can use the extension or expansion levels for your profit targets when trading.

Final Words

The Fibonacci sequence is the basis for the Fibonacci levels in Forex trading. It was described by an Italian mathematician Leonardo de Pisa, and its derivative, the golden ratio, seems to occur in several aspects of life apart from Forex. In Forex, the levels derived from the Fibonacci ratios help to identify potential support and resistance levels before the price gets there.

This does not constitute investment advice or personal recommendations as your specific financial circumstances have not been considered. No warranty is given in regards to the accuracy and completeness of information. Past performance is not an indicator of future results.