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Fibonacci Analysis

 

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Fibonacci Numbers

Fibonacci numbers are the result of work by Leonardo Fibonacci in the early 1200's while studying the Great Pyramid of Gizeh. The Fibonacci series is a numerical sequence comprised of adding the previous numbers together, i.e., (1,2,3,5,8,13,21,34,55,89,144,233 etc..)

An interesting property of these numbers is that as the series proceeds, any given number is 1.618 times the preceding number and 0.618% of the next number.

(34/55 = 55/89 = 144/233 =0.618) (55/34 =89/55 =233/144 =1.618), and 1.618 =1/0.618.

This properties of the Fibonacci series occur throughout nature, science and math and is the number 0.618 is often referred to as the "golden ratio" as it is the root of the following polynomial x^2+x-1=0 which can be rearranged to x= 1/(1+x).

So that is where the fib # 0.618 comes from. The other fibs 0.382 and 0.5 commonly used in technical analysis have a less impressive background but are just as powerful in Technical analysis.

0.382=(1-.618)=(0.618*0.618)

and 0.5 is the mean of the two numbers.

Other neat fib facts (0.618*(1+0.618)=1 and (0.382*(1+.618))=0.618.

Fibonacci numbers are commonly used in Technical Analysis with or without knowledge of Elliot Wave Analysis to determine potential support, resistance, and price objectives. 38.2% retracements usually imply that the prior trend will continue, 61.8% retracements imply a new trend is establishing itself. A 50% retracement implies indecision. 38.2% retracements are considered natural retracements in a healthy trend.

When applied on charts, Fibonacci Retracement Levels are used as support and resistance levels: 0.236, 0.382, 0.500, 0.618, 0.764.
0.382, 0.500 and 0.618 - are the most important to watch for.

To apply Fibonacci Retracement Levels we first need to be able to recognize a pattern as on the picture below:

We already know that market moves in waves. So for each A-B wave there is a B-C retracement. As you probably already guessed market consists of such ABCD wave patterns in one big wave there could be many smaller similar pattern waves. To apply Fibonacci Retracement Levels we will need to find such patterns on our charts.

Let us take a look at a real chart example:

Now that we know how to identify patterns that we could apply Fibonacci numbers to, we can take a look at an example how this actually works:

Fibonacci Extension Levels are used as targets for taking profit: 0.382, 0.500, 0.618, 1.000, 1.382, 1.500, 1.618.
0.618, 1.000 and 1.618 - here are the most useful for traders.

Fibonacci retracement and extension levels carry important information for both experienced and novice forex traders to help identify entry and exit points during the trade.

Three Fibonacci retracement levels: 0.382, 0.500 and 0.618 - are used as points to enter the trade. Looking at any chart it is obvious that the best entry position would be at the lowest possible swing - e.g. at 0.618 retracement level.

But the price tends to choose different levels to change its direction: it can hit 0.382 and go straight back, sometimes it gets to 0.500,and at times even pierces deep to the 0.618 level. But still, if the price chooses to respect Fibonacci rules it will stop at one of those levels and Fibonacci traders will already be waiting for this opportunity to enter the trade.

When plotted on the chart, Fibonacci tool automatically shows predicted price extension. This feature can be used to determine risk that trader is ready to take in particular trade. Because we also know where to set the stop loss, we can easily calculate risk/reward ratio. In other words, it will be our money management approach. It is considered wise to enter only those trades that promise a 1:3 risk/reward ratio.

For example, the trade is worth entering, when you have 30 pips of possible losses (in the case of unprofitable trade when a stop loss order will be hit), and 90 or more pips of potential wins in the case when trade will turn winning.

Many traders use Fibonacci numbers to set stop loss ant take profits orders. It makes sense, because Fibonacci retracements play a role of major support and resistance levels.

Fibonacci extension levels -  0.618, 1.000 and 1.618 - are used to set profit goals. So, what trader needs to do after placing an order is just to look at extension levels and set a «take profit»/ «close trade» order. In more than 50% of the cases traders tend to use a 0.618 extension level as the primary target to lock in profit. If the market is very active, traders can simply reset their positions and ride a rally further to the next 1.000 or even 1.618 Fibonacci extension point.  For traders who like to take additional protection steps and trade safe, there is one more point to consider: such as locking in some partial profits during the trade.

Although Fibonacci method has its defined rules, many forex and stock traders worldwide are using their own combined styles and approaches, not to mention setting different objectives for every particular trade. Because of that we will be more comfortable with plotting two or more Fibonacci retracements to see where interests of majority of traders are merging.

And so, merging Fibonacci retracement levels will show more potential points at which the price might reverse its direction. Same idea would also apply for setting profit taking targets. Here trader should closely look at the chart and tighten their profit limits when the price gets closer to profit target zone. The other option is simply to opt for the lowest extension level and trade safe. 

 

Topics Related to Fibonacci Analysis:

  

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Part 2: Forex Brokerage Firms & Forex Trading Platforms

Part 3: Forex Charts

Part 4: Forex Fundamental Analysis & Economic News Releases

Part 5: Technical Analysis

Part 6: Technical Indicators

Part 7: Fibonacci Analysis

Part 8: Elliot Wave Theory

Part 9: Candlestick Chart Analysis

Part 10: Money Management

Part 11: Trading Psychology

 

 

 

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