Fibonacci is composed of different elements used by traders to identify different trading signals. They include Fibonacci Retracement, Fibonacci Time frame, Fibonacci Fan, Fibonacci Arcs, Fibonacci channels and Fibonacci extension. Fibonacci Retracement and Extension are the most commonly used Fibonacci and the most easy to use, so we shall mainly focus on these two.
The Fibonacci Retracement and extension.
The Fibonacci Retracement is composed of series of sequences that are used to identify the potential areas of support and resistance. These sequences were introduced to the West by an Italian mathematician known as Leonardo Pisano Bogollo from Pisa.
He based on certain mathematical relationships expressed as ratios between numbers in a series and these ratios were used in different fields like biology, music, art and architecture.
The ratios are got from aserie of numbers starting with; 0,1,1,2,3,5,8,13,21,34,55,89,144,233,377,610,…..
The numbers start with 0, then 1,to get the next number, you get the previous number plus the current number, eg the next number will be 0+1=1. And the other numbers are got by adding the two numbers following each other. So the next in the sequence would be , 1+1=2,1+2=3,2+3=5, 3+5=8, 5+8=13,8+13=21,…to infinity.
If you divide a number with the previous numbers, you get an approximate value equal to 1.618. For example 34/21 =1.6190, 55/34=1.6176, 89/55=1.6181, 144/89=1.6179.
If you divide a number by the next number, you get an approximate value equal to 0.618. For example; 13/21=0.619, 21/34=0.6176, 34/55=0.6181, 55/89=0.6179, 89/144=0.6180,……..
If you divide a number by a number two places higher, you get an approximate value equal to 0.3820 For example 13/34=0.382, 21/55=0.3818, 34/89=0.3820, 55/144=0.3819,…
If you divide a number by another three places higher, the approximate value will be 0.2360. E.g 34/144=0.2361, 21/89=0.2359, 55/233=0.2360,……
The 1.618 is also known as the Golden Ratio/ Golden Mean or Phi.
The good news is, You will not be required to calculate all these ratios because they are provided on the chart software or you can do that by using the Fibonacci calculator in case you are interested.
Doing all these calculations we are showing you how these ratios are derived so that you are not confused when you see them on the chart. What’s important is knowing how to use them and when.
The commonly used ratios are;
0.236, 0.382, 0.500, 0.618 Retracement levels. The Retracement levels help traders to identify where and when the market reverses from to continue moving. These levels are usually expressed in percentages as 23.6%, 38.2%, 50%, 61.8% and 100% for easy use. Price tend to pause or reverse as it approaches Fibonacci points above therefore behave the same way as support and resistance .
These levels are also used by traders to determine targets, entry and exit points and the stop loss order. Some traders use Retracement only while others use both Retracement and the extension levels. We will discuss all that in the next sessions.
0, 0.382, 0.618, 1.000, 1.382, 1.618 are the main extension levels. These levels can also be expressed as percentages. The extension levels of 38.2%, 61.8%, 100%, 138.2%, and 161.8% help traders to know how far prices are likely to go compared to the previous swings to get the right target profit levels. These are mainly used to determine targets, especially take profit target.
How to draw and use fibonacci retracement levels
The Fibonacci Retracement is drawn by identifying two extreme points on a swing, high and low and drag the line to join the two points. The vertical line displays fibonacci retracement ratio levels which range from 0.0% to 100% .
To use the Fibonacci Retracement tool on your chart, select the Fibonacci retracement tool on your chart or trading platform on the MT4,go to Insert >Fibonacci>Retracement, or simply click on the icon on the toolbar .
The too has 0 and 100 levels in adding to other levels we mentioned earlier, 0 and 100 mark the end and starting point of a price wave.
When trading in an uptrend, extend the tool upwards from the starting point to the high of a price wave. The 0.0 should be at the wave high and the 100 at the wave low. This is how it should appear
If the trend is down, extend the tool downwards from the starting point to the low of a price wave. The 0.0 should be at the wave low and the 100 at the wave high. This is how it should appear.
From the above chart, price pulled back at 0.0% from the low of the main wave(impulse wave) which is 0.0% fibonacci retracement level and retraced the 38.2% . If it pulls back 61.8% it will be at the 61.8% Fibonacci level.
The 61.8% level mean the price has retraced much of the prior move and 100% makes a complete wave retracement. Levels such as 23.6% and 38.2% mean the price has only retraced a small portion of the prior move.
In a very strong trend, you are likely to see shallow pullbacks to 23.6%, 38.2% and sometimes 50.0%. When a trend has been moving for sometime forexample during the middle or towards the end of a trend, retracements/pullbacks are likely to hit the 61.8 or 78.6 levels.
The chart below shows fibonacci retracement in a strong downtrend, GBP/USD,M30 Chart.
Once you have learnt how fibonacci tool works, you can use it to watch potential areas on the market where price always hold and reverse and rely on that to determine your entry signals.
In the next lesson we shall look at how to use fibonacci retracements to enter a trade.
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