4 Common, Costly Fibonacci Mistakes

03/23/2011 7:00 am EST

Focus: FOREX

Getting to know these Fibonacci missteps will make you better equipped to avoid them—and the potentially disastrous consequences that often follow.

By Richard Lee

Every foreign exchange trader will use Fibonacci retracement at some point in their trading career. Some will use it just some of the time, while others will apply more regularly. But no matter how often you use this tool, what's most important is that you use it correctly each and every time.

Improperly applying technical analysis methods will lead to disastrous results, such as bad entry points and mounting losses on currency positions. Here we'll examine how not to apply Fibonacci retracements to the foreign exchange markets. Get to know these common mistakes and chances are you'll be able to avoid making them—and suffering the consequences—in your trading.

1) Don't Mix Fibonacci Reference Points

When fitting Fibonacci retracements to price action, it's always good to keep your reference points consistent. So, if you are referencing the lowest price of a trend through the close of a session or the body of the candle, the best high price should be available within the body of a candle at the top of a trend: Candle body to candle body; wick to wick.

Misanalysis and mistakes are created once the reference points are mixed, going from a candle wick to the body of a candle. Let's take a look at an example in the euro/Canadian dollar currency pair. Figure 1 shows consistency: Fibonacci retracements are applied on a wick-to-wick basis, from a high of 1.3777 to the low of 1.3344. This creates a clear-cut resistance level at 1.3511, which is tested and then broken.

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Figure 1: A Fibonacci retracement applied to price action in the euro/Canadian dollar currency pair

Figure 2 below, on the other hand, shows inconsistency. Fibonacci retracements are applied from the high close of 1.3742 (35 pips below the wick high). This causes the resistance level to cut through several candles (between February 3 and February 7), which is not a great reference level.

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Figure 2: A Fibonacci retracement applied incorrectly

By keeping it consistent, support and resistance levels will become more apparent to the naked eye, speeding up analysis and leading to quicker trades.

2) Don't Ignore Long-Term Trends

New traders often try to measure significant moves and pullbacks in the short term without keeping the bigger picture in mind. This narrow perspective makes short-term trades more than a bit misguided. By keeping tabs on the long-term trend, the trader is able to apply Fibonacci retracements correctly in the direction of momentum and set themselves up for great opportunities.

In Figure 3 below, we establish that the long-term trend in the British pound/New Zealand dollar currency pair is upwards. We apply Fibonacci to see that our first level of support is at 2.1015, or the 38.2% Fibonacci level from 2.0648 to 2.1235. This is a perfect spot to go long in the currency pair.

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Figure 3: A Fibonacci retracement applied to the British pound/New Zealand dollar currency pair establishes a long-term trend

But, if we take a look at the short term, the picture looks much different:

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Figure 4: A Fibonacci retracement applied on a short-term time frame can give the trader a false impression

After a run-up in the currency pair, we can see a potential short opportunity in the five-minute time frame (Figure 4). This is the trap.

By not keeping to the longer-term view, the short seller applies Fibonacci from the 2.1215 spike high to the 2.1024 spike low (February 11), leading to a short position at 2.1097, or the 38% Fibonacci level.

This short trade does net the trader a handsome 50-pip profit, but it comes at the expense of the 400-pip advance that follows. The better plan would have been to enter a long position in the GBP/NZD pair at the short-term support of 2.1050.

Keeping in mind the bigger picture will not only help you pick your trade opportunities, but will also prevent the trade from fighting the trend.

NEXT: Don't Rely on Fibonacci Alone


3) Don't Rely on Fibonacci Alone

Fibonacci can provide reliable trade set-ups, but not without confirmation.

Applying additional technical tools like Moving Average Convergence Divergence (MACD) or stochastic oscillators will support the trade opportunity and increase the likelihood of a good trade. Without these methods to act as confirmation, a trader will be left with little more than hope of a positive outcome.

(For more information on oscillators, see our tutorial on Exploring Oscillators and Indicators.)

Taking a look at Figure 5 below, we see a retracement off of a medium-term move higher in the euro/Japanese yen currency pair. Beginning on January 10, 2011, the EUR/JPY exchange rate rose to a high of 113.94 over the course of almost two weeks. Applying our Fibonacci retracement sequence, we arrive at a 38.2% retracement level of 111.42 (from the 113.94 top). Following the retracement lower, we notice that the stochastic oscillator is also confirming the momentum lower.

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Figure 5: The stochastic oscillator confirms a trend in the EUR/JPY pair

Now the opportunity comes alive as the price action tests our Fibonacci retracement level at 111.40 on January 30. Seeing this as an opportunity to go long, we confirm the price point with the stochastic, which shows an oversold signal. A trader taking this position would have profited by almost 1.4%, or 160 pips, as the price bounced off the 111.40 level and traded as high as 113 over the next couple of days.

4) Do Not Use Fibonacci Over Short Intervals

Daytrading the foreign exchange market is exciting, but there is a lot of volatility.

For this reason, applying Fibonacci retracements over a short time frame is ineffective. The shorter the time frame, the less reliable the retracement levels. Volatility can, and will, skew support and resistance levels, making it very difficult for the trader to really pick and choose what levels can be traded. Not to mention the fact that in the short term, spikes and whipsaws are very common. These dynamics can make it especially difficult to place stops or take profit points as retracements can create narrow and tight confluences. Just check out the below example in the Canadian dollar/Japanese yen pair.

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Figure 6: Fibonacci is applied to an intraday move in the CAD/JPY pair over a three-minute time frame

In Figure 6 above, we attempt to apply Fibonacci to an intraday move in the CAD/JPY exchange rate chart (over a three-minute time frame). Here, volatility is high. This causes longer wicks in the price action, creating the potential for misanalysis of certain support levels. It also doesn't help that our Fibonacci levels are separated by a mere six pips on average, increasing the likelihood of being stopped out.

Remember, as with any other statistical study, the more data that is used, the stronger the analysis. Sticking to longer time frames when applying Fibonacci sequences can improve the reliability of each price level.

The Bottom Line

As with any specialty, it takes time and practice to become better at using Fibonacci retracements in forex trading. Don't allow yourself to become frustrated; the long-term rewards definitely outweigh the costs. Follow the simple rules of applying Fibonacci retracements and learn from these common mistakes to help you analyze profitable opportunities in the currency markets.

By Richard Lee, contributing editor, DailyReckoning.com

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