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How to enter a trade in forex - Fibonacci Retracements

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Forex trading
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Lesson 12

The Fibonacci retracements are widely used for technical analysis and are particularly useful for short term speculators, regardless of whether you are trading forex or crypto markets.

The Fibonacci levels can be used by traders to identify potential areas of support and resistance where price can continue the trend or reverse.

Mysterious as it sounds, the Fibonacci levels’ wide use by many market practitioners proves their usefulness. At the core, the Fibonacci levels often tend to coincide with key support and resistance levels.

You might know support and resistance levels are one of the fundamental blocks of trading. Price never moves in a straight or a parabolic direction, and even if it begins to, the correction in prices often coincides with some key support and resistance levels.

This is where the Fibonacci retracements give traders an estimate of where prices could reverse. When one combines the Fibonacci tool with other aspects of technical analysis, he or she can pick trades with a high level of confidence.

The Fibonacci numbers

The Fibonacci levels, or numbers, are attributed to Leonardo of Pisa. A famous Italian mathematician, Leonardo combined his knowledge with that of the far east in developing the Fibonacci numbers, or series.

The series, or numbers, is based on the sum of the previous two preceding numbers starting with 0 and 1. Thus, the simplest of Fibonacci numbers are 0, 1, 1, 2, 3, 5 and so on.

When dividing any two numbers, after a certain point, the number remains constant. This constant is known as the golden number, or the Fibonacci number, which is 0.618, rounded to three decimals. It is also referred to as phi or the golden ratio.

Part of the mystery of the golden ratio comes from observing nature itself. The golden ratio was prominently used in Greek architecture. It is no wonder the Fibonacci number, or the golden ratio, eventually found its way into the financial markets.

Based on the golden ratio, or phi (0.618), different levels were also developed. The most common Fibonacci levels are 0.382 and 0.236. Some even make use of the 0.50 as one of the key levels, but this is usually redundant considering the number’s proximity to the golden ratio.

How to enter a trade

To apply the Fibonacci ratio, the first step is to measure the length of the price action, or the wave. This is often accomplished by identifying a major high and a major low, or vice versa.

Once the high and low are identified, traders then use the Fibonacci retracement tool to measure this wave. Using the values of 0.236, 0.382, and 0.618, the tool automatically plots these levels.

Traders then wait for the price to drop or rally to these levels and, based on their analysis, take a position accordingly.

The general rule of thumb is that price action, more often than not, tends to reverse off these levels. Despite being a rule of thumb, readers should note there is no guarantee that price will reverse.

How to use Fibonacci levels in Forex

To trade Fibonacci retracements successfully, the first aspect you need is a strong rally or a decline in price action with minimal pull backs. This ensures as price tends to rise or fall based on momentum, the chances of a correction increase considerably.

Typically, in a rally, a correction can end at one of the three retracement levels. Ideally, one sees the correction coinciding with the 0.618 or 61.8% level. However, this needs to be validated with the fundamentals and other technical indicators as well.

In the forex markets, traders use the Fibonacci levels to identify the support and resistance levels. Then, when price starts to retrace to one of these levels, a valid trade is taken in the direction of the previous trend.

In trend trading terminology, the Fibonacci retracements are potential dips in a rally and rallies in a dip. In other words, the pullback to one of the key levels and the subsequent rally or decline often indicates buying into a trend after a healthy correction.

Thus, in a way, the Fibonacci tool and the retracement levels go hand in hand with trend trading.

Fibonacci trading strategy

To trade forex using the Fibonacci retracements, you will have to set up a trading strategy. Based on the strategy's rules you might buy or sell currency pairs. Of course, the onus remains on the trader on when to pull the trigger for long or short positions.

Fibonacci Buy entry

Fibonacci Buy entry

In the above USDJPY chart, we notice, after a strong decline in price and after forming a bottom, price action posted a reversal. This reversal was met with only small retracements to the rally. After the peak was formed, price action started to move sideways.

Using the Fibonacci retracement tool, we then obtain the 38.2% and 61.8% levels. Following the multiple bounces off the 38.2% level, price action then surges strongly. Purchasing USDJPY at this level would have resulted in successful trade.

Fibonacci Sell entry

Fibonacci Sell entry

In the above USDJPY example, we can see price dropped sharply. However, the pullbacks were not significant. After price posts a major low, we see price trending higher.

Using the Fibonacci tool, when we measure this down leg in price, the 61.8% and 38.2% levels are evident. In the above example, we can see price posted a sharper correction to the 61.8% level. Considering this is a resistance level, traders can then sell USDJPY.

While the above strategy might look easy to trade, in reality, traders need to be sharp and one step ahead of the game. Once a major high and low are formed, traders should plot the Fibonacci levels and anticipate potential reversals.

Sometimes, price can post a fake move and reverse at a 38.2% Fibonacci level only to reverse back and rise to the 61.8% level. It takes considerable practice to trade forex successfully with the Fibonacci levels’ help.