For those who love trading market retracements, then Fibonacci indicator is the best indicator to do technical analysis with. The indicator is developed to assist traders identify various levels that the market could probably hit as it retraces.
If you are familiar with forex trading, you could agree that trading retracements is normally the most difficult thing. This is because, to start with, you must first identify if the market is truly retracing or just gaining momentum to continue with the current trend. Then you have to determine when the retracement is most likely to end so that you are not left trading retracement when the market has already resumed its initial trend.
Understanding the logic behind the Fibonacci indicator
The Fibonacci indicator is based on the famous Fibonacci sequence that was developed by a mathematician by the name of Leonard Fibonacci. Although it is an old mathematical formula, the Fibonacci sequence has found quite a lot of use in arrays of field with Forex trading being one of them.
Majorly, the Fibonacci indicator focuses on the mathematical relationship and expressions between the Fibonacci sequence numbers. The Fibonacci sequence number are as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc. and each number is the sum of the previous two numbers. This sequence can continue infinitely as long as you keep counting.
Another mathematical relationship between the Fibonacci numbers is that the next number is approximately 1.6 times larger than the previous number excluding the 0,1,1,2 section.
Actually, the ratios between the Fibonacci sequence numbers is the basis of the retracement levels generated by the Fibonacci indicator.
The Fibonacci indicator normally plots levels with 23.6%, 38.2%, 50%, 61.8% and 100%. And it is drawn by taking two extreme points on the chart. You may ask where this levels come from and we have only found out that the ratio between the numbers is 1.618 roughly equal to 1.6.
A 100% is the maximum retracement level and that does not need calculations.
The 61.8% is obtained by dividing a Fibonacci sequence number by the immediate next number on the right on the sequence. E.g. 55 divided by 89.
50% is the midpoint.
38.2% is obtained by dividing a number in the Fibonacci sequence by the number that is two places on its right. E.g. 34 divided by 89.
The 23.6%is obtained by dividend any number on the Fibonacci sequence by a number that is three places on the right. E.g. 21 divided by 89.
Using the Fibonacci indicator
The most important ratio in the Fibonacci sequence is the 61.8% ratio since it is the ratio of the most immediate numbers. This ratio is also referred as the golden ratio when it comes to the Fibonacci indicator.
To use the Fibonacci indicator, you click on the Fibonacci indicator button which is normally at the top left side of the trading chart for those using the Metatrader 4/5 trading platform. Then, you will have to identify the two extreme point that you want to use to draw the Fibonacci retracements.
When choosing the two extreme point, you should choose a point before an abrupt market movement and the point after the abrupt market movement. The abrupt movement are those movements which in most cases result from market news releases.
The psychology behind it is that whenever the market moves abruptly, there’re are very high chances of the markets moving back to the original point so that it can start over better at a slower pace that all market participants can be able to follow.
You should start drawing the Fibonacci indicator at the point before the abrupt market change and end it at the point after the movement. This way, the 100% retracement will be at the point where you started drawing your Fibonacci. Meaning, if the market prices moves back to that point, ther will be a complete retracement.
However, you should only use this indicator in cases where you are sure retracements are inevitable. Like in the case of major news releases.
Once you draw the Fibonacci, you should set your target at the 61.8%; this is where you take profit should be. To get where to place you stop loss, you can use a pivot point indicator and place it on the nearest resistance or support level.
When a retracement starts, it in most cases will go to the 61.8%. Don’t be too greedy to expect it to reach the 100%. If it gets to the 100%, well and good you will have taken your profits and exited the market.
However, to add an extra level of risk management, you can choose to use a trailing stop with the first target being the 23.6%. With that, the profits will get locked and you will be safer in case the retracement wasn’t that powerful to get to 61.8%.