Forex 103Lesson 4

Basic Fibonacci

The Fibonacci number sequence is a naturally occurring phenomenon which many people believe can be applied to financial markets.

When applied to trading, the Fibonacci sequence is expressed as ratios by

dividing a number in the sequence by its preceding number(s).

The major Fibonacci ratios are:

0.236 (23.6%) 0.382 (38.2%) 0.618 (61.8%) 1.272 (127.2%) 1.414 (141.4%) 1.618

(161.8%)

The minor Fibonacci ratios are:

0.236 (23.6%) 0.500 (50.0%) 0.786 (78.6%) 0.886 (88.6%) 1.130 (113.0%)

How do we Apply it to Trading

Fibonacci ratios are primarily used in trading by what’s called

Fibonacci retracements and extensions.

The ratios for a Fibonacci retracement range from 0% to 100%, while

the ratios of an extension start at 100% and continue upwards. We

will only consider as far as the 1.618 (161.8%) for simplicity.

There are numerous strategies which use Fibonacci, and some of them

do require a high level of technical analysis. Because of this I will

focus on one of the simplest for this article. It’s a simple trend

continuation play, using support or resistance.

Fibonacci RetracementIf you were looking to measure a swing low, the retracement is pulled from the high to the low, of the

swing low (and vice versa for a swing high). This lays out the retracement levels across the price

action.

When a Fibonacci retracement is used this way, the main objective is to observe how the market has

behaved around the key Fibonacci levels. Has the market rallied back into the 0.382 retracement and

found resistance like in the schematic above?

The 0.382 and the 0.618 are the two levels I’ll be using in the following strategy. The reason for this is

that when a market finds support or resistance within the zone between these two levels, it usually

means trend continuation, provided the market is already trending.

Fibonacci ExtensionIf you were looking to measure a swing low, the extension is pulled from the high to

the low, and back to the high, of the swing low (and vice versa for a swing high). This lays out the extension levels beyond the current price action.

When used in this way, the Fibonacci extension can be used to predict where the market

may next find support or resistance, and therefore can be used to set profit targets

when trading with the trend, as discussed above.

Fibonacci Based Strategy

With this knowledge we can now build a simple trend trading strategy using Fibonacci. The rules are as

follows:

Look for a trending market (higher highs followed by higher lows for a bullish trend, or lower lows

followed by lower highs for a bearish trend).

Wait for a swing low to form in a bearish trend, or a swing high to form in a bullish trend

For a bearish trend, pull the retracement from the high to the low (see image below), or from the low

to the high in a bullish trend.

If the market has paused between the 0.382 and 0.618 retracement, and if this zone coincides with a

recent support or resistance level, enter on the close of the current candle.

Considering the image below, your stop loss would go behind the swing high at 1.4425.

Profit targets can be placed at the extension levels of 1.272 and 1.618. Move stops to breakeven when

target one is hit.

If the trade were to run to full targets, this is how it

may look. One thing to be mindful of is that when

setting profit targets in this manner there is always the chance that the market will double bottom before it

hits target one.

Depending on where you enter you may be able to justify placing your first target at the bottom of the swing low. As a general rule, aiming to maintain a risk to reward

ratio of 1 : 1 is a good idea. You can have an inverse risk

to reward, it just means your win rate needs to be higher.