Developing a trading strategy using Fibonacci

Developing a trading strategy using Fibonacci

Fibonacci (Leonardo Pisano Bogollo) was a 13^th-century mathematician from Italy who come up with the Fibonacci numbers. The Fibonacci sequence is a string of numbers with different ratios and unique mathematical properties. These ratios are widely present in the universe. Their unique precise features are present in biology, architecture, and nature. Due to their presence in nature, it is believed that they can be used in financial markets to identify reversal points in the market. Their extensive use in financial markets has led to what is known as a Fibonacci trading strategy.

Fibonacci trading strategy

The Fibonacci number series consists of numbers that start with 0 and 1. After 0 and 1, the next number can be calculated by summing up the two previous numbers. The sequence continues to infinity, as shown below.

0,1,1,2,3,5,8,13,21,34,55,89,144,233,377………

These numbers relate uniquely,and a Fibonacci trading strategy is built based on their relationship. Let us look at the essential ones that you need to know to master forex trading using Fibonacci.

• If you take any number in the sequence and divide it by the previous one, you get approximately 1.618, which forms the basis of Fibonacci extension levels. E.g., 34/21 or 377/233
• If you take a number in the series and divide it by the next number, the result is approximately 0.618. The Fibonacci retracement level of 61.8% is anchored on this ratio. E.g., 21/34 or 233/377.
• The Fibonacci retracement level of 38.2% is arrived at by diving a number in the series by another number that is two positions higher, which approximates to 0.382

The 1.618, whose inverse is 0.618, is called the phi, Golden ratio, or the Golden mean. The phi forms the mathematical basis of the shape of snail shells, sunflowers, spiral galaxies of outer space, Greek vases, playing cards, and the Parthenon.

A Forex trading strategy is built on these ratios, which are divided into retracement and extension levels. These retracement and extension levels provide values that show where possible reversal points in the market could take place.

Fibonacci retracement levels

These levels are anchored on the prior move in prices. They help provide support and resistance price levels where the price action could reverse in direction. Such price levels could then be used to establish entry points into the market. The most commonly used Fibonacci retracement levels are 26.6%, 38%, 61.8% and 78.6%.

• After a massive rise in price, a trader would want to find a possible point where price could begin falling to find a support level before resuming the uptrend. Such a level is established by measuring the price movement from bottom to top using Fibonacci retracement levels to develop a buy pattern.
• After a massive fall in price, a trader would want to establish a possible price retracement level, before the price corrects lower and resumes the overall downtrend. Such a level is found by measuring the move from top to bottom using Fibonacci ratios to establish a sell pattern.

• The buy Pattern: As you can see from the buy-pattern above, there is a significant rise in price from M to A.Traders will use the Fibonacci ratios to determine how far the price will retrace the M-to-A move, to find a support level (B) before it bounces back higher. The support level B is an ideal buying point and can be either 78.6%, 61.8%, 38.2% or 23.6% Fibonacci retracement of the move from M to A. In an uptrend, the buy-pattern helps to determine how low the price will swing before it swings high again (swing low to swing high).
• The sell pattern: This helps to establish a possible point at which to sell when market prices are in a downtrend. This can be established by using Fibonacci retracement to measure M-to-A move from the top to the bottom to determine how high the market will swing before finding a resistance level B, after which it will swing back lower (swing high to swing low).

Fibonacci extension levels

They help to establish how far prices will move after finishing a retracement before finding new support and resistance levels to reverse. After using Fibonacci retracement to enter into a trend, you use the Fibonacci extension to target the end of the trend and exit appropriately. This is where the Fibonacci Golden ratio of 1.618 comes in handy. 161.8% Fibonacci extension level is the most popular, and it is anchored on the Golden ratio.

The entry point B (the bounce), is determined by retracing the M-to-A move using Fibonacci retracement levels. To establish how far the trend could extend before finding a resistance level at point C, you will need to measure the retracement from A to B using the Golden ratio,which will be at 161.8% of the move from A to B. the Golden ration is used to find a possible exit point in an uptrend.

In a downtrend, a trader will enter at point B (the correction) and use the 161.8% Golden ratio to determine point C, which is the furthest point the trend could extend, before finding a reversal level.

Therefore, a Fibonacci trading strategy is built on Fibonacci retracement levels and Fibonacci extension levels. Fibonacci retracements help to establish resistance and support levels to enter a trade following the preceding trend. On the other hand, Fibonacci extension levels help in calculating the extent to which a trend could move before finding new resistance and support level to reverse, and are used to find exit levels. You don’t have to know about the calculations, because the trading platform comes with a Fibonacci retracement tool used to calculate price movements and plot Fibonacci ratios.