Trading Forex with Fibonacci (Part 2)

11/19/2015 9:00 am EST

Focus: FOREX

Huzefa Hamid

Senior Analyst, DailyForex.com

Huzefa Hamid of The Forex Room and DailyForex.com continues his three-part trading lesson on Fibonacci with a discussion of how to use retracements to spot profitable trades.

Yesterday (see Part 1), we looked at the Fibonacci sequence of numbers and how they are used to discover ratios that are found in nature and in the markets. The key ratios we discovered were:

  1. 23.6%
  2. 38.2%
  3. 61.8% (The Golden Ratio)
  4. 78.6% (Square root of The Golden Ratio)
  5. 88.6% (Square root of 0.786)
  6. 161.8% (1 divided by 0.618)

Before moving on, we are going to add some further Fibonacci ratios that are found in the markets:

  1. 100%
  2. 112.7% (Fourth root of 161.8%)
  3. 127.2% (Square root of 161.8%)
  4. 138.2% (Addition of 100% and 38.2%)
  5. 200%
  6. 261.8% (Addition of 100% and 161.8%)

Now, with a more complete list of Fib ratios, let's look at how they are applied to the markets. Once again, we will use currency charts in this article, but any market can be analyzed using Fibonacci.

Fibonacci on Charts: Retracements

We will begin with one of the most primary concepts in trading: the "retracement." This is where the price moves in a direction, then goes back over that move before continuing in the original direction.

This example of a four-hour euro/dollar (EUR/USD) chart shows a retracement:

chart
Click to Enlarge

There are three parts: the "initial move," the "retracement," and finally the "subsequent move."

Of course, retracements can also be retracing in the other direction. For example, in this four-hour euro/yen (EUR/JPY) chart, the initial move is down and the retracement is up:

chart
Click to Enlarge

Let's start to tie in the Fibonacci ratios with the markets beginning with retracements. By definition, a retracement traces a portion of the initial move. The amount that the initial move is retraced can be measured in relation to the Fibonacci levels.

Now, when I say, "This is a 78.6% Fibonacci retracement," all that means is that the retracement is 78.6% of the size of the initial move. So if the initial move was 100 pips up, the retracement would be 78.6 pips down.

Let's go back to the same charts we looked at before, starting with the EUR/USD chart:

chart
Click to Enlarge

The price moved up from point 1 to point 2, then moved back precisely 78.6% of that distance to point 3 before moving back in the original direction.

Let's take a look at the same EUR/JPY chart that earlier showed an upward retracement, this time with the Fib levels in place:

chart
Click to Enlarge

Now you should have the idea: price moved down from point 1 to point 2, and then moved back up 78.6% of that distance to point 3, before moving back in the original direction.

NEXT: Multiple Fibonacci Lines

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Multiple Fibonacci Lines

Can you start at different points to measure your retracement? Yes. A retracement can be measured with different Fibonacci levels using different starting points for the initial move.

In the following chart of the aussie/dollar (AUD/USD), the price moves down to point 1, retraces back up to point 2, then continues moving down in the original direction. Several highs were made before the price reached point 1. I've marked the two most recent and prominent highs as point X and point Y.

chart
Click to Enlarge

When the price moved from point X to point 1, it retraced 61.8% of that distance to point 2 before continuing the downward move. This is marked by the red horizontal line.

Now, if you chose to use point Y as the starting point from which to measure the retracement, point 2 was a 112.7% retracement of the distance from point Y to point 1 (as marked by the blue horizontal line). Therefore, a retracement can in fact go past the start of the initial move depending on where you choose to start your measurement. This is why the Fib levels above 100% are important.

The AUD/USD example also illustrates another point we will be examining later in this series of articles: different Fib levels produce confirmation points to allow us to plan trades.

Looking over charts, you can find examples of small retracements that reach just the 23.6% level, to larger retracements that go back all the way to 88.6% of the initial move.

You can examine retracements from the smallest charts, e.g. five-minute bars, to long-term charts using weekly bars. The principles apply in exactly the same way.

As this series of articles unfolds, we will look further at how these principles can be applied to trading scenarios to find entry points and price targets, as well as how to protect risk.

In Summary

  1. Fibonacci levels used in trading start from 23.6% and extend well beyond 100%
  2. A retracement can be measured in relation to the Fibonacci ratios
  3. Multiple Fibonacci levels on a chart can confirm key price areas

      Note: Many of you use MetaTrader for your charting. On MT4, the following button is the Fibonacci retracement tool:

      chart
      Click to Enlarge

      Once pressed, click and drag it on your chart from your selected start point to your finish point. Where you click first is where the 100% level will appear, and where you finish dragging is where the 0% level will be set.

      Double-click the Fib lines that appear and you can move the ends from the small squares at the ends of the handle to fine tune your selected points. Right-click and go to "Fib Properties" on the pop-up menu to add levels, change colors, etc.

      Remember, to get the 0% and the 100% the right way around, think about what you're measuring: if you're measuring a retracement, you want to make sure the 0% is at the start of the retracement.

      See also: Fibonacci Analysis: Master the Basics

      By Huzefa Hamid, co-founder, The Forex Room

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