Using Fibonacci In Your Forex Trading System
By Bret Freak
Fibonacci retracement analysis is a very widely known and used technical analysis tool, used by traders to mainly calculate possible targets for entry and exit points, and in determining potential levels of support and resistance. The thought behind Fibonacci retracements suggests that the price of whatever currency or market youre observing will often retrace a certain percentage of a previous move, and find support or resistance at the main Fibonacci levels before continuing in its original direction.
What makes this particular indicator superior to most, is that its known as a leading indicator, not lagging. In other words it has predictive powers, unlike other technical indicators that are informative of change in trend, after it has already occurred, fibonacci retracement levels show you possible turning points before they occur.
These levels are formed by drawing a trend line between two extreme levels (high & low) of a main market move, then dividing the vertical distance by the main Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, 78.6% and 100%.
The majority of good charting packages have the ability to do this automatically for you. For example in Metatrader, all you have to do is this: First you choose a main market move, select the Fibonacci button (the one that has a couple of horizontal lines on it, along with the letter F), hold your mouse button down, and drag the line from the bottom of the main move, to the most recent top (for uptrends). In market moves that are moving downwards you would apply the Fibonacci tool starting at the peak of the move. Metatrader then automatically draws in horizontal lines at the main Fibonacci retracement levels.
You may have heard of a famous trader by the name of William. D. Gann who implemented fibonacci levels in his trading, he
also mentions them throughout his books and courses. Of all the levels he talked about, he put the greatest significance on the 50% retracement level. He even went as far as to saying: you can make a fortune trading this one level alone. (How to Make Profits in Commodities). Hearing this from such a widely known and very successful trader shouldnt be taken lightheartedly. Although this book was about trading commodities, many traders use the same principals today, in markets around the world, including the market.
How can Fibonacci retracement levels be used?
So the question now is, can you trade based on Fibonacci levels alone? The fact is that it is very hard to determine at which Fibonacci retracement level prices will retrace. Thats why trading systems that use Fibonacci also incorporate the use of other indicators, or price action. For example, if you were to observe that two other indicators are indicating a reversal, while price is near the 61.8% retracement level, this may give you extra confidence that a change in trend is about to occur.
Or alternatively, you could observe a candlestick reversal pattern occurring at a key fibonacci retracement level. For example if a shooting star was formed at a 61.8% retracement level, this would indicate that prices have reached a natural resistance level, and price action is telling you its time for a reversal.
Just like pivot points, Fibonacci retracement levels can act as a very helpful guide in determining possible reversal points. But, keep in mind that this is just a tool, and shouldnt be used alone. By combining the power of fibonacci retracement levels, along with your other technical tools, you should be able to develop a sound trading system and add confidence to execute a trade.
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