Fibonacci levels have become very popular with traders as a means of predicting the behaviour of the market.  Fibonacci was a mathematician who discovered a simple series of numbers.

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144.

They are generated by adding the previous two numbers in the series to get the next number.  So 0+1 = 1, 1+1=2, 1+2=3 etc.  After first few numbers the ratio between any two consecutive numbers is always the same.  So 144/89= 1.618 89/55=1.618

The reason these numbers are so important is that the ratio between these numbers occur in nature everywhere.  This ratio is called the golden ratio and occurs in pretty much everything in nature from the shape of your face to the branches of trees to the movement of planets.

As well as the golden ratio there are a number of other ratios that are generated by various other means such as dividing a term in the sequence by the next higher term or dividing a term with a term one step away.  You wont need to know how to calculate these as your trading platform will do it for you.  The actual ratios that are important to us are

Fibonacci Retracement Levels

0.236, 0.382, 0.500, 0.618, 0.764

Fibonacci Extension Levels

0, 0.382, 0.618, 1.000, 1.382, 1.618

So what does Fibonacci have to do with forex?  Well someone, somewhere noticed that the Fibonacci ratios were turning up in the forex market behaviour.   Which is not surprising since the market is controlled by human behaviour and if you have a big enough sample of people it can be thought of as being controlled by nature.  Whether or not that is actually true doesn’t matter anymore as enough people use Fibonacci in forex that it has now become a self-fulfilling prophecy.

Fibonacci retracement and extension levels

Fibonacci supporters predict that when the market is trending and the price changes direction temporarily the amount it will retrace will be a ratio of how much it has moved in the trend direction so far.

To use Fibonacci levels, we simply use our trading platform to mark the from the lowest swing point to the highest swing point.

A Swing High point  is a candlestick with at least two lower highs on both the left and right of itself.

A Swing Low point is a candlestick with at least two higher lows on both the left and right of itself.

By using the Fibonacci tool, the trading platform automatically calculates where the Fibonacci retracement or extension levels are.  These levels identify where you can enter trend to gain the most profit and where you can exit a trend to lock in the most profit.

In the following images, we set up our Fibonacci levels and notice how price drops to the 23.6 level before moving back up. And if you weren’t fast enough to catch it the first time it actually test the support level again a while later.

In the second image with a new different swing high point that support level lines up with the 38.2 level

So if you entered the trade here, where can you exit?  Fibonacci extension levels are created above the latest swing point.   With the swing points set exactly where we set them for the retracement levels you can see that the 61.8 and the 100 levels were both good points to take profits.

Once again it is wise to remember that technical tools such as Fibonacci simply provide guidance and higher probabilities of predicting the market.  They are not 100% and should be used in conjuction with other methods such as candlestick patterns, trend lines, support and resistance levels.  And always have a good risk management strategy in place by placing stops at appropriate points.

Use your demo account to try out the Fibonacci function.  If you don’t already have one you can open a free demo account and download the Metatrader MT4 trading platform by clicking here.  On the metatrader account, click on Insert > Fibonacci > Retracement  or Insert  > Fibonacci > expansion.  Then click and drag from a swing low to a swing high to see the extension or retracement levels.  Try it and you'll be amazed how often the price follows the fibonacci levels

Next lesson - Moving Averages