Trading with Fibonacci

What's Fibonacci All About?

First, for the uninitiated, we'll start with a brief summary. Leonardo Pisano Fibonacci was a mathematician who traveled widely with his father, an Italian diplomat. His book, Liber abaci, was published in 1202 after his return to Italy, and introduced the numeric sequence that came to be known by his name.

Fibonacci includes a series of ratios that are found throughout all of nature. These ratios appear just about everywhere - in music, in Greek architecture, in the alignment of planets, in the way a tree sprouts its leaves, in the way a mollusk grows its shell. There are simply countless examples of this phenomenon.

What on earth does any of this have to do with trading? If you are a natural-born skeptic like me, you're probably not terribly impressed by anything you've heard so far, and rightly so. There is no logical reason to believe that any trading vehicle (stock, commodity, or currency) will suddenly stop and change direction of its own volition when the price or exchange rate retraces by a particular ratio.

So why does Fibonacci work in the Forex market? Because Fibonacci ratios are a deeply ingrained part of the Forex culture. Big banks, hedge funds, and individual traders alike all pay close attention to these ratios, and frequently place their orders at Fibonacci retracement levels.

If enough orders accumulate at a particular level, the combined power of these orders can actually change the direction of the exchange rate when that level is achieved. This is the essence of the self-fulfilling prophecy that we discussed in last week's newletter.

If my assumption is correct that Fibonacci works in the Forex market not because of magic but due to a self-fulfilling prophecy, then there are certain conclusions that we can extrapolate from this premise:

Fibonacci Is More Effective on Longer-Term Charts

If we truly believe that Fibonacci is a self-fulfilling prophecy, then we should live by the credo, "the more, the merrier." In other words, the more orders that are placed at a particular level, the more likely it becomes that the level will hold as support or resistance.

What can improve the chances that there will be a large quantity of orders at a particular Fib level? Visibility is the key. If the other players can't see the Fib level, they can't place their orders accordingly.

For example, if a Fibonacci level forms on a five-minute chart during the Asian trading session, any opportunity to place a trade based on this retracement is likely to come and go before European and American traders have wiped the sleep from their eyes. Since many of these traders will never observe this opportunity, there will be fewer orders placed at that level. This makes it less likely that the level will hold when the price reaches that area.

However, if the same scenario occurs on the daily chart, traders all around the world will have the time and the opportunity to place their orders accordingly. Since Forex is truly an international market, with traders located on every part of the globe, this aspect of Fibonacci trading takes on added significance.

Fibonacci Is More Effective on Commonly Used Retracement Levels

The most commonly used Fibonacci ratios are 38.2%, 50%, and 61.8%. However, 23.6%, 78.6% and 100% are also legitimate Fib levels. Some traders even use Fibonacci "extensions" that go beyond 100%, such as a 161.8% retracement. There are also Fibonacci Arcs, Fibonacci Fans, and Fibonacci Time Zones.

Which of these techniques will be the most effective? If we truly believe that a sizable quantity of orders (or a quantity of sizable orders) will make the difference, then we must give more weight to the levels that garner the most attention - the 38.2%, 50%, and 61.8% levels. In Fibonacci, as in many aspects of trading, sometimes it's better to keep things simple.

Click the Trading with Fibonacci header link above to learn more about trading with Fibonacci retracement and extension levels.

Good day and good trading.