The Fibonacci trading strategy is one of the most well known and commonly used long-term technical strategies on the forex. It attempts to place price action in the proper context by using the Fibonacci sequence, a close representation of the historical “Golden Ratio.” Fibonacci numbers are not only frequently used in the financial markets but are also applied to physics, geometry, engineering, and art.
Within the arena of forex trading, there are many uses of this unique mathematical construct. This particular Fibonacci trading strategy is dependent on a phenomenon called a “pullback.” To fully understand how pullbacks work, we must first discuss a more fundamental concept — the trend.
A trend is simply a directional move in price over a defined period. When looking at each price change individually, it can be a challenge to find a distinct pattern. However, by looking at the bigger picture, trends are readily identifiable. Spotting a valid trend is a critical part of implementing a Fibonacci trading strategy. Without the presence of a trend, this strategy is of limited effectiveness.
Breaking Down The Fibonacci Trading Strategy
The image above shows a moderately short trend which is the kind of trend that we will focus on when breaking down this particular Fibonacci trading strategy. The trend is made up of three legs: two going up and one going down.
Since the overall direction of the trend is up, the middle part, where there is a momentary downfall, is called a “pullback.” The problem with identifying pullbacks is that when we see a trend start to reverse it is very hard to distinguish a pullback from a reversal of the trend. This is where the Fibonacci trading strategy comes in. The technique allows us to analyze the data, evaluate price action, and craft a final decision.
To learn more about using trends to determine trades: Trend Trading – Forex Trading Strategies
Fibonacci numbers and ratios have been famous among mathematicians and artists for hundreds of years. They are found frequently throughout nature and when applied to the financial markets, can function as great analytical tools. No math is required to use these numbers — the software trading platforms automatically perform all necessary calculations for us. In practice, executing a Fibonacci trading strategy in forex is straightforward and intuitive. The only task that we must complete is to make a decision based on the lines which appear on the graph.
Applying The Fibonacci Sequence
In practice, there are several Fibonacci numbers derived from the sequence. The three most important are 0.382, 0.5, and 0.618. Also, keep in mind 0.764 and 0.236.
On the chart above, the Fibonacci ratios are the purple lines drawn horizontally. They represent the 38.2%, 50.0%, and 61.8% retracements of the prevailing uptrend. By examining how far the pullback has reached on the Fibonacci scale we can determine two things: whether the price will resume to the bull or reverse into a fresh bearish trend. Either way, we are able to craft a plan to trade each potential scenario.
The general Fibonacci trading strategy rule states that as long as the price remains above the 61.8% line, we can expect the trend to continue. This indicates that the bearish price action is only a pullback, not a full-blown reversal. On the flip side, once the price crosses the 61.8% line, we must treat it as a start of a bearish trend. If we are long this market, it is time to close out and move on to the next trade.
The chart above illustrates a pullback that forms a bottom at around the 50% Fibonacci marker. This indicates that the price will most likely rise and the overall upward trend will continue. In accordance with this fact, we are able to adjust our trade management properly. If we are long this market, then holding the position is proper trade management strategy. In the event that we are looking for a short entry, then waiting for better trade location is the play.
Either way, the use of the Fibonacci sequence has given us a concrete framework for crafting position management positions on-the-fly. We are now able to routinely identify our ideal take profit and stop loss price levels. With this information, we can balance risk with reward and maximize reward while limiting risk.