Fibonacci & RSI: Perfect Together

04/24/2014 9:00 am EST

Focus: FOREX

Jeremy Wagner

Head of Daily FX Education, FXCM

Jeremy Wagner of DailyFX Education details how you can combine Fibonacci and RSI together to identify and confirm good trading opportunities.

Fibonacci retracement ratios have been used by traders for many years. The ratios can identify hidden levels of support and resistance as they identify areas where a partial retracement may reverse. For those unfamiliar with Fibonacci, the common retracement ratios are 38.2%, 50%, 61.8%.

As traders are learning about the Fibonacci ratios for the first time, the next logical question the students ask is “how do I know which ratio to focus on?”

It is a good question and the market’s price action will provide a clue if a particular Fibonacci retracement ratio is likely to be respected creating a market turn.

Said another way, rather than blindly entering into a trade because it hit a particular retracement ratio, how about if we let the market provide us confirmation signals that it is likely to turn?

We can use the relative strength index (RSI) to help us confirm if a Fibonacci ratio is repelling prices.

RSI Confirmation of a Fibonacci Retracement Level

(Created using FXCM’s Marketscope 2.0 charts)
Click to Enlarge

As we can see above, the USD/JPY has the three Fibonacci retracement levels added to the chart (horizontal blue lines). The first level, the 38.2% level, barely resisted prices.

However, we can now see that the 50% level is providing some resistance. Additionally, the RSI is showing divergence, which is a bearish signal as well.

Divergence is where the price makes higher highs, but the oscillator makes lower highs. Divergence means that momentum is slowing. Slowing momentum into a resistance level is a good recipe for a trading opportunity.

When prices fell below the black support trend line, it is further confirmation that the temporary uptrend is losing momentum. A trader would enter on a break of the black trend line, then place the stop loss just above the recent swing high.

Look to take profits at a distance at least twice the size of the distance to your stop loss. This will give you a 1:2 risk to reward ratio.

Let the trade evolve until it reaches your stop loss or take profit level.

Risk a small portion of your account balance, less than 5%, on all open trades.

By Jeremy Wagner, Head Forex Trading Instructor, DailyFX Education

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