Fibonacci theory as we know it today originated from a 13th century Italian mathematician by the name of Leonardo of Pisa, otherwise known as Leonardo Fibonacci. His work that eventually led to such mainstream technical analysis standards as Fibonacci retracements originated from a sequence of numbers that led to the discovery of the Golden Ratio, approximately 1.618. This ratio can be found in many areas of nature, science, music, and, very importantly, the financial markets. This includes the forex market.
The Fibonacci sequence begins as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377 … A noteworthy aspect of this sequence is that the sum of each two consecutive numbers results in the next number in the series. Therefore, 0+1=1, 1+1=2, 1+2=3, and 2+3=5, etc. As the Fibonacci sequence grows to greater values, the ratio of one number to the one before it progressively approaches the Golden Ratio of 1.618.
In forex trading and analysis, the primary purpose of Fibonacci analysis is to determine potential retracements within trends. Trends move in one general direction, up or down, but there are always periods of retracement within trends, where the currency exchange rate moves in a counter-trend manner. In a currency uptrend, for example, there are invariably a significant number of bearish moves that retrace a portion of the prior bullish moves.
Therefore, there are always minor dips in uptrends and minor rallies in downtrends. These areas are among the best places to enter trades in the direction of the trend. In an uptrend, for example, traders always seek to buy low and sell high. Buying on a minor dip within an uptrend means entering at a relatively low price. In a downtrend, traders always seek to sell, or short, high and then buy back, or cover, low. Selling on a minor rally within a downtrend means entering at a relatively high price. These are considered advantageous trade entries.
Fibonacci retracements allow traders to estimate price regions where price may retrace to during dips and rallies. The primary Fibonacci retracement percentages are based on the inverse of the 1.618 Golden Ratio, which is 0.618, or 61.8%. Besides this key level, there is also the important 38.2%. Another very significant Fibonacci retracement percentage is 50%. Other percentages include 23.6% and 76.4%. For the most part, however, the most popular Fibonacci retracement levels, by far, are 38.2%, 50%, and 61.8%.
Fibonacci retracement percentages are used primarily by forex traders to forecast the location of potential bounces on dips and rallies where high-probability trade entries may be made. For example, in an uptrend, when a bearish retracement occurs, many traders will wait for any potential bounce around the 38.2% retracement of the original uptrend move. If this occurs, these traders may enter long trades, pushing price further up in its bounce from the 38.2% price level.
Other popular uses of Fibonacci analysis include identifying price targets in the form of projections and extensions. Additionally, Fibonacci levels can be excellent tools for confirming other technical studies, like support and resistance. Fibonacci analysis is one of the most popular aspects of technical analysis in the forex market. Perhaps because of this, it is relatively common that significant price action events occur around key Fibonacci price levels.
- James Chen, CTA, CMT
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