David Parker writes: Given a forex trader’s endless search of his next trading position, the Fibonacci tool falls under the scope of technical analysis and it’s used for the prediction of future price levels. Many technical analysts have considerable respect for its abilities in predicting future rates, and learning how to use Fibonacci numbers may contribute a lot to your forex trading career. However, as it is the case with most technical indicators, this tool is best to be combined with other technical sources and fundamental data for a more holistic feedback on future price movements.

Fibonacci numbers’ origin and method of calculation is peculiar, as they are based on a series of numbers that apparently are found in nature. Moreover, this discovery is not recent by any means and was not initially connected to forex trading as it was a mathematical concept developed by the mathematician Leonardo Fibonacci about 800 years ago. In summary, the Fibonacci ratios used for technical analysis today are calculated based on that series of numbers developed by Fibonacci:

The main Fibonacci ratios used by forex traders come from this series of numbers. The first ratio is 61.8% and is calculated by dividing any number in the sequence by the number that follows it, and the answer will be very close to 0.618 or 61.8%. For example:

Similarly, the other two significant Fibonacci ratios 38.2% and 23.6% are calculated by dividing a number in the sequence by two or three numbers following that, respectively. Luckily, you will not have to do these calculations by hand each time you want to use the Fibonacci tool on MT4 as the ratios will be placed automatically.

GBP/USD one-hour chart

The example above uses a one-hour price chart for the GBP/USD where the Fibonacci ratios 61.8%, 38.2%, and 23.6% are marked with green horizontal lines. Each of these is used as reference for potential retracement points, and also the 0%, 50%, and 100% levels are marked for additional reference. So, if the current price is below one of the levels but it is moving upwards, that level may be considered as a resistance point for the price. Similarly, if the current price is above one of the levels but it is heading downwards, that level can be considered as a support level.

The Fibonacci retracement ratios are not solely used by technical analysts as trend-reversal levels, but also for setting up stop loss orders. Take for example a scenario where you are in a long position and you are fortunate because the price is currently heading upwards. The first Fibonacci retracement level under the current price can act as a support level, and so it provides the option to place the stop loss order just below that Fibonacci level with a view to save yourself from increased losses. The same idea applies when you are in a short position and the price is moving downwards. The first Fibonacci retracement level above the current price acts as a resistance level, and by placing a stop loss order just above that level you might save yourself from excess losses on that position.

Even though the Fibonacci tool is a widely used method by technical analysts to get hints on possible price trend reversals, it also carries some level of risk. This is why a lot of successful forex traders use Fibonacci ratios combined with another technical indicator, or even fundamental analysis and economic data, to get a clearer picture on their future trading positions.

By David Parker,
www.easy-forex.com

© 2014 Copyright David Parker - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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