Fibonacci – An overview

Fibonacci retracement levels are widely watched by FX market participants, as they often mark significant supply/demand areas. Nimble traders can use these levels to spot trading opportunities on many different timeframes. The studies were invented by Leonardo Fibonacci, an ancient European mathematician who found a universal relationships among a number series that seemed to be found all throughout nature (reproduction rates, planetary relationships, etc).

The basic premise behind the use of this analysis is that strong markets cannot go in one direction forever, and that healthy markets will periodically pullback before resuming the underlying direction. Whether you believe that these levels hold because of some universal mathematical law or whether they hold because traders look at them and base trades on them (thereby becoming a self-fulfilling prophecy) is irrelevant because they are widely used, and if used properly, can lead to profitable trades.

How is it calculated?

Fib levels can be used by drawing a trend line between two significant points, typically a low to a recent high, and inserting percentage levels. These levels represent areas where the pullback may subside. The most commonly used levels are 38.2%, 50%, and 61.8%, although 21.4% and 78.6% are also used. When price retraces to one of the earlier levels (21.4% or 38.2%) it is a powerful signal that the market trend is very strong, as traders are aggressively trying to enter the overall trend.

Sample Use of Fibonacci Retracements in Trading

The chart below shows how Fibonacci retracements can be applied in trading. Note how the market is in a downtrend and then, as expected, pulls back to a Fibonacci level -- thereby creating the perfect opportunity for a trader to enter a position -- prior to resuming the downtrend.


The pair moved up 300 pips immediately after finding support at the 38.2% retracement level. Depending on your entry point and exit strategy, you should have been able to net at least 200 pips in profit. If you had a longer time horizon with looser stops, then you may still be in the trade, over 1300 pips later.

Confirmation is Key
Traders don't simply enter positions when price reaches one of these levels. It is not known know whether price will find support at 21.4%, 38.2% or any other levels. As such, traders need to receive some sort of confirmation (from price action or oscillators) that the level did hold the support. The chart below illustrates how a trader can use Fibonacci retracements in conjunction with another indicator -- in this case, Stochastics -- to identify legitimate trading opportunities.


Pair moved down over 500 pips immediately after finding resistance at the 38.2% retracement level. Depending on entry point and exit strategy, a trader should been able to net at least 300 pips in profit. Retracement level also coincided with negative crossover. There was only one positive day for the next 7 trading days, and the positive day's range was very small. The pair moved back up and found resistance at the 38.2% retracement level once again, and coupled with a double top formation and another negative crossover, this was a major bearish signal. The next few trading days were volatile, so traders may have been shaken out. If stop loss levels had been placed far enough away, the pair moved down to 1.2864.