Trading strategy using Fibonacci retracements
Leonardo Pisano, nicknamed Fibonacci, was an Italian mathematician born in Pisa in the year 1170. His father Guglielmo Bonaccio worked at a trading post in Bugia, now called Béjaïa, a Mediterranean port in northeastern Algeria. The young Leonardo studied mathematics in Bugia, and during extensive travels, he learned about the advantages of the Hindu-Arabic numeral system.
In 1202, after returning to Italy, Fibonacci documented what he had learned in the "Liber Abaci" ("Book of Abacus"). In doing so, he popularized the use of Hindu-Arabic numerals in Europe.
The Fibonacci number sequence
In the "Liber Abaci," Fibonacci described the numerical series now named after him. In the Fibonacci sequence of numbers, after 0 and 1, each number is the sum of the two prior numbers. Hence, the sequence is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 and so on, extending to infinity. Each number is approximately 1.618 times greater than the preceding number.
The Golden Ratio
This figure – 1.618 – is called Phi or the Golden Ratio. The inverse of 1.618 is 0.618. The Golden Ratio mysteriously appears frequently in the natural world, architecture, fine art and biology. For example, the ratio has been observed in the Parthenon, Leonardo da Vinci's Mona Lisa, sunflowers, rose petals, mollusk shells, tree branches, human faces, ancient Greek vases and even the spiral galaxies of outer space.
Fibonacci levels used in the Financial Markets
The levels used in Fibonacci retracements in the context of trading are not numbers in the sequence; rather they are derived from mathematical relationships between numbers in the sequence. The basis of the "golden" Fibonacci ratio of 61.8% comes from dividing a number in the Fibonacci series by the number that follows it.
For example, 89/144 = 0.6180. The 38.2% ratio is derived from dividing a number in the Fibonacci series by the number two places to the right. For example: 89/233 = 0.3819. The 23.6% ratio is derived from dividing a number in the Fibonacci series by the number three places to the right. For example: 89/377 = 0.2360.
Fibonacci retracement levels are depicted by taking high and low points on a chart and marking the key Fibonacci ratios of 23.6%, 38.2% and 61.8% horizontally to produce a grid. These horizontal lines are used to identify possible price reversal points.
The 50% retracement level is normally included in the grid of Fibonacci levels that can be drawn using charting software. While the 50% retracement level is not based on a Fibonacci number, it is widely viewed as an important potential reversal level, notably recognized in Dow Theory and also in the work of W.D. Gann.
Fibonacci Retracement levels as part of a Trading Strategy
Fibonacci retracements are often used as part of a trend-trading strategy. In this scenario, traders observe a retracement taking place within a trend and try to make low-risk entries in the direction of the initial trend using Fibonacci levels. Simply put, traders using this strategy anticipate that a price has a high probability of bouncing from the Fibonacci levels back in the direction of the initial trend.
In this example, we are observing the EUR/USD on the 4H chart. We see that the trend is in a down direction, depicting the Euro's weakness. The red curve is the 200 exponential movement average, applied to the chart and it shows that the price is deeply under the curve in a Bearish bias. We apply the Fibonacci Retracement on the Meta Trader platform from the beginning of the trend (the top) to the lowest point of the trend (yellow horizontal lines). As you can see they are marked with the percentage values of the ratios. We can see here that 23.6, 38.2 and 50 levels are key levels here as the price couple of times tested the zones. The last tests before the price to breach the level and to move up is 23.6 as we can see that the pair has tried many times to go pass it. In the end, the Bulls won and now it seems the price will try to make a move on 38.2.
The bottom line
Fibonacci retracement levels often mark reversal points with an uncanny accuracy. However, they are harder to trade than they look in retrospect. The levels are best used as a tool within a broader strategy that looks for the confluence of a number of indicators to identify potential reversal areas offering low-risk, high-potential-reward trade entries.