Fibonacci in Forex Trading - Learn More

Category: Technical Analysis | Saturday, January 24th, 2009

On January 17th 2008 I posted an article about Fibonacci numbers and the way you can use them in forex and stock trading. In that article I explained why Fibonacci numbers work and why we can see some of them specially 0.618 everywhere in the world and in everything. I suggest you to read that article first and then come back and read this one. I strongly believe that using the Fibonacci numbers in trading, whether in stock or forex, needs much more experience and information than what I have already explained in that article.

In this article and maybe some other articles in future I try to explain more about using the Fibonacci numbers because it really works. Fibonacci numbers really work in forex trading because they reflect the psychology of the traders and trading forex and stock is all about the psychology of the traders: When most traders decide to sell, the price goes down and when they decide to buy, the price goes up.

How can we know when the traders decide to buy or sell? Fibonacci numbers are one of the tools that reflect what the traders may have in their minds.

Why the Fibonacci numbers can reflect what the traders have in their minds? Are they magic numbers?

Well! For our trading job we just need to know that Fibonacci numbers work and can show us the way. Why they can show us the way is the question that its answer has no effect in our trading BUT I am sure you are eager to know. In the previous article I have explained it. When Fibonacci numbers are the key numbers in everything in the world from the arrangement of atoms, molecules, flowers and … to planets, stars, galaxies and … and when they can be seen in all of our body organs and even in our DNA molecule which is the database of all of our characteristics and behaviors, SO they can be seen in the forex and stock price movements because as I said the movement and direction of the price is the result of the behavior of the traders (buyers and sellers).

In that previous article I asked a question that only one of you looked eager to know. I want to repeat this question here and give the answer after one year:

I do not know why only Fibonacci numbers (specially 0.618) and not any other number (for example 0.264) can be seen in everything in the universe. If you ask “why 0.618?” I have no answer for it but if you ask why this 0.618 can be seen in everything from the smallest things like atoms to the biggest things like galaxies and there is no exception for that I have an answer. Fibonacci numbers can be seen in everything simply because everything is created by the same person and the same rules and regulations.

It makes sense, doesn’t it?

Ok! Now lets learn more about using the Fibonacci numbers in our trades.

One of the most important problems of the traders is that they really don’t know where to plot the Fibonacci levels. They can not find the start and stop point for drawing the Fibonacci levels and they choose wrong places to plot the Fibonacci levels and this causes them to make mistakes.

1. Range:

One of the best places to plot the Fibonacci levels is the high and low of a range. When the market is slow and in fact is in an indecision situation that means traders are waiting for each others’ decision and nobody wants to take risk before the others, the price fluctuation will become very small and the price goes up and down between a narrow range. We can see ranging in all different time frames. We can see the market ranging tens of times a day in one minute chart, several times in 5 minutes chart and a few times per year in the daily chart. A ranging in the one minutes chart can last several minutes and in a daily chart can last several days. So with any of these time frames that you work, the rules are the same. It is just the length of the ranging time which is different.

A range, whether long or short, will be broken because the market can not stay in an indecision situation forever. A range can break down or up and this is what we want to know to take our positions and follow the market.

If you are a Fibonacci trader, all you need is finding a range in one of the time frames and then finding the high and low of the range. Let me show you some an example.

Please follow the notes on the image below as you are reading these explanations. The below chart is the GBP/USD daily chart. GBP/USD started a range from about 2008.01.22. The distance between high an low of this range was over 1000 pips. It was still tradable but obviously the market was not in a trend. When we were at about January 2008 we could not guess that we are at the beginning of the range but when the price went down on 2008.02.20 and retested the same support line at 1.9329 and then started going up again, we could know that we have a strong support at 1.9329 that can be the low of a range. Then when the price went up and made a high at 2.0392 on 2008.03.14 and then went down and retested the 1.9329 support for the third time on 2008.05.14 we could be sure that we are in a ranging market. Please note that in a ranging market one of the triangle, wedge or even head and shoulders patterns may be seen.

If we were looking for a trend, all we need to do was waiting for the range to be broken down or up. How we could know if the range will break down or up? There are some ways to guess. For example making lower highs tells us that the range will break down. In the below case, when the price retested the 1.9329 support on 2008.05.14, it went up again but couldn’t reach the 2.0392 resistance and made a lower high at 2.0157 on 2008.07.15. When the price makes a lower high it means the market doesn’t have enough potency to go up and reach the previous high it already had. So this can be considered as a signal that the range will break down. Also the high we have on 2008.03.14 is a lower high in comparison with the high we have on 2007.11.09. But please note that cases are different and not all of the lower highs mean that the price will break down.

This is how you should see the chart and analyze the market and guess what will happen.

So far we have a range and all of the signals (higher lows) tell us that this range should break down. However when we are not sure what will happen and what the direction of the breakout can be, we have to wait until the breakout happens. We really don’t have to guess it. We can wait and see it and when the breakout happens we can take the proper position. When the low of the range is broken down we can go short and when the high of the range is broken up we can go long.

Now it is time to plot our Fibonacci levels. As I guessed that the range would break down, I plot the Fibonacci levels from the low of the range to the top. So the 0.0 level will be placed at the high of the range and the 100.0 level will be placed at the low and also all other 161.80, 261.80 and 423.60 levels will be placed below the range:

If I had predicted that the range will break up I should have plotted the Fibonacci levels from top of the range to the bottom and so the 161.80, 261.80 and 423.60 levels would be placed above the range.

Now lets look at the chart with a bigger magnification (the below image) and I will tell you how and when you could take the proper position and where would be your target. The 2008.08.08 candlestick tells us that the range is broken down because it is closed below the range low. We could go short at the close of this candlestick if we are not already short after the formation of the 2008.07.15 lower high. Our target would be the 161.80 level and the stop loss had to be placed above the open of this candle.

It is time to tell you about the importance of some of the Fibonacci levels. When a range is broken up/down the 161.80 level is the guaranteed target level that in 95% of the cases will be reached by the price. If the breakout is strong enough, the 261.80 and even the 423.60 will be reached too. Among the Fibonacci inside levels (the levels that are placed between the 0.0 and 100.0 levels) the 23.60 and 38.20 are the most important one and as you can see the 2008.07.15 lower higher is formed exactly below the 23.60 level and before this lower high we have a small lower high which is formed below the 38.20 level (the red arrow). Do you see how exactly and precisely the Fibonacci levels work???

Ok! So we went short at the close of 2008.08.08 candlestick and our target was the 161.80 level. So we made 520 pips so far. The prices start going up and down around the 161.80 level BUT the 2008.08.22 candle tells us that bears (sellers) are so strong and they want to take the price down to 261.80 level. So we went short at the close of this candle and our target would be the 261.80 level and we made another 900 pips. The stop loss had to be placed several pips above the open of this candle which is actually above the 161.80 level.

Lets take a look at the next parts of the chart. As you see (the below image) when the price reached the 261.60 It went up to retest the 161.80 level (follow the numbers - #1). It is time to emphasize on the importance of 161.80 level. This level works as a very strong support/resistance. When it is broken up/down, it will be retested in 95% of the cases. So you should always expect to see the price goes up to retest the broken 161.80 level as a resistance. So the price goes up and retests the 161.80 level (#2) and then goes down. We could go short again here, set the target at 261.80 and the stop loss above the 161.80 levels.

Again when the price broke down the 261.80, it went up and retested this level but the 2008.10.20 candle indicated that it would keep on going down again. Why the 2008.10.20 candle? Because it is a bearish candle the is closed below the low and the close of the last 5 candles. It also has covered the whole bodies and shadows of the last three candles and have formed a bearish signal pattern which is called Dark Cloud Cover. Learn the candlesticks and their patterns!

So we went short again at the close of the 2008.10.20 candle, set the stop loss above the 261.80 level and the target at 423.60 level and made about 1100 pips.

Could you go long when you saw the price is going up after breaking down the 261.80 level? You could but you should not because it was against the trend direction.

Now let me tell you about a different way that we could trade with this downtrend. This is the method that some conservative traders use to trade and I like it because it is safer and wiser.

We could wait until the range becomes broken down and the downtrend becomes confirmed. Then we should have waited for the price to start going up and makes the first correction, flag or consolidation. Then when it started following the downtrend to go down once again, we could go short. Take a look at the below image and you will know what I mean. I am now talking about the Elliott Waves. What I am trying to say is trading the second Elliott Wave which is the best one.

2. Second Wave:

Just have an eye on the below image and follow the numbers as I am explaining. It is exactly the above chart but with a different way of trading.

In many cases a trend will be started when a range becomes broken (As you saw above). As I said ranging means indecision. When we have a ranging market, it means traders are waiting for each other to take the risk. They want the price to start moving and then take the proper position. They don’t want to take any risk before the others. When the market breaks the range (#1 in the below image), the traders who have been waiting for the market to move and break the range, follow the newly started trend and take the proper position (short position in this case) and this will provide more fuel for the price to move to the breakout direction (to go down in this case).

Then after a while that the market keep on moving, some traders decide to close their positions and collect their profit and so the price starts moving to the other direction (#2 in the above image). But there are also a lot of other traders who keep their positions and wait for the price to start moving to the direction of the breakout again. These traders will add to the positions they had and at the same time some other traders who are late will come and see the trend and take the proper position. So the price starts moving to the direction of the trend again (#3 in the above image). This is where most traders take their positions because they believe that the trend is confirmed only when the price starts following the breakout direction once again.

When the price starts following the breakout direction, it is the beginning of the second Elliott Wave which has the biggest movement and is the best to trade. Some professional traders only trade this wave. At the above image, the second wave is started at #3 and is finished at #8.

Fibonacci levels are the best tools to show us the waves and our entry and exit points:

1. Wait for the range breakout (#1).
2. Wait for the price to start moving against the breakout (#2).
3. Wait for the price to start following the breakout direction again (#3) and take the proper position (short position in this case) and set the target to the first low support line (#4) and set the stop above the 0.0 level.
4. Wait for the price to break down the first low support line (#4).
5. If it couldn’t do that close your position and wait for the price to follow the trend direction again.
6. If it breaks down the first low support line (#4) but went up to retest the broken support (#5) close your position and wait for the price to follow the trend direction again.
7. If it couldn’t breaking up the broken support and started following the trend direction again (#5 and #6) then take the proper position again (short position in this case) and set the 161.80 level as the target.
8. If it broke down the 161.80 level (#7) keep your position or if you have closed it take it again and set the target to 261.80 level (#8).
9. Wait for the price to retest the 161.80 (#9) and then if failed to break the 161.80 and started following the trend direction again, take the position (short position in this case) and set the target to 261.80 again.
10. It is possible that it breaks the 261.80 level but retest it (#11, #12 and #13). If you see the trend is strong enough to move toward the 423.60 level, take the proper position (short position in this case) and set the target to 423.60 and place the stop loss above the 261.80 level.

Your main profit could be made by trading the second wave (#3 to #8) and some traders do not take any position after that because in most cases the market becomes choppy after the second wave.

Ok! I think it is enough by now. I will try to have more articles about using the Fibonacci levels and show you more examples and trades.

Exercise:

1. Back Testing:
- Try to find ranges like the above example in different time frames and with different currency pairs.
- Find the breakout and their confirmations and reasons.
- Plot the Fibonacci levels and find the entry and exit points.
- Do this with as many currency pairs and time frames as you can.

2. Live Demo Trading:
- Choose a volatile currency pair like Eur/JPY or GBP/USD
- Go to a short time frame like 1min or 5min.
- Wait for a range to form.
- Find the high and low of the range.
- Predict the direction of the breakout or wait for the real breakout.
- Plot your Fibonacci levels.
- Take the proper position with you demo account.
- Set the stop loss and target.
- Repeat this as many times as you can.

Note: The reason of choosing a short time frame is that just for the practicing purpose I don’t want you to wait a lot for a range and breakout to form. I am not suggesting you to trade using the short time frames like 1min or 5min. This is up to you and it depends on everybody’s tastes and conditions.

Further Reading:

30 Comments:
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Comment by priawansyah

2009-01-25 00:00:31

Thanks You So Much Vahid! Fantastic Work you have done. You are truly a real professor of graphic in FX Trading. Your contributions to this Blog are greatly appreciated.

Cheers
Priawansyah