You will be surprised to know the answer which is – we don’t know – as Fibonacci numbers work on almost everything from DNA to the universe. It works on everything that you see in this world and so is in our forex world. Nobody knows why these numbers have such a feature that they are present everywhere in the universe even in the arrangement of the petals in flower.
Fibonacci series, when used properly, can determine the support and resistance levels. This is certainly an uncomplicated way to set up target orders as well as stop loss. Anybody who wants to trade successfully in the forex market should use Fibonacci series.
To understand how Fibonacci series is used to determine the movement of the price of a currency pair, let us consider the following two set of ratio:
Price Retracement Levels
0.236, 0.382, 0.500, 0.618, 0.764
Price Extension Levels
0, 0.382, 0.618, 1.000, 1.382, 1.618
The first set of ratio under the price retracement level is used for determining the support and resistance levels. These are the most common ratios for the traders to play with. That is why every market player expects that the traders all over the world are opening and closing their positions according to these ratios. And the fact is – they are making profits!
The traders are using the second set of ratio under the price extension level to determine the extension of the price if it breaks the retracement level. This is the set of most common ratio that traders use to determine the price extension.
As both long and short term traders are becoming aware of the accuracy of Fibonacci series in forex, many brokers are offering a package in which both retracement and extension levels are calculated for the traders. Although one should use his analysis to determine the levels, Fibonacci is an excellent way to make sure that your interpretation is correct.
It should be kept in mind that Fibonacci can only be applied if you understand the concept of swing highs and swing lows.
A swing high is created when the price creates a short term new high with two highs on the left and the right side. These two highs should be lower than the short term new high.
A swing low is created when the price creates a short term new low with two higher lows on the left and the right side. These two higher lows should be higher than the short-term new low.
Fibonacci Retracement Levels
Suppose the market is in an uptrend and to apply the price retracement level to determine the ratio and the corresponding price level, you have to search for a swing low as well as a swing high. Now, once you have identified both, place the cursor on the swing low, right click and drag it to the swing high and again right click. Let us understand this with examples:
The following chart shows the retracement levels:
The swing low in this chart is at $71.31, and the swing high is $89.83. Right clicking plots the retracement levels at the swing low and dragging it all the way up to the swing high. In the chart, you can see the retracement levels are created at $75.68, $78.38, $80.57, $82.76, and $85.46. This means, if the market retraces, the traders are going to put the new buy orders at these levels. One of these levels could become a new support level.
Now, let us see to which side the market moved and what happened after that. The following chart shows the further price movement:
The markets have given a nice buy opportunity at 0.382 as after touching the swing high it retraces and falls to a level of 0.236 and then crossing the level of 0.382 before moving back.
Fibonacci Price Extension Level
The price extension ratio and price levels can be determined by clicking on a swing low and dragging it all the way up to the recent swing high and then clicking on the swing high and dragging it up to swing low. Let us understand this with an example:
In the following chart, extension levels have been created by dragging the swing low of $38.20 to the swing high of $47.67 and then dragging it back to the swing low. This has created new Fibonacci levels at $44.64, $48.29, $50.54, $54.19, $57.84 and $60.09. The traders will place a sell order at these levels to make profits in their long trade.
Now, let us see what happened further:
After making a swing low, the market again picked up the pace and flattened at a level of 0.382 before picking up a pace to cross 1.000 after which it retraced to 0.618 and again picked up the pace going to 1.382 and 1.618. A level of 1.000 is good for booking profits.
Both these methods are similarly applicable when the markets are in a downtrend.
Many beginners think that it is Fibonacci and it can sure short yield profits. This is not true. It is an excellent method when combined with other techniques and analysis, but one cannot rely trading on this alone. So, it is important that you practice on a demo account and use different techniques and strategies to create what works the best.