Fibonacci Trading Strategies – An Introduction
INTRODUCTION
Fibonacci trading refers to a set of strategies driven by a popular method of market analysis. It’s popular not only in the Forex (currency trading) markets but also among professional traders of stocks, futures, and other markets around the world.
There are countless ways to use Fibonacci levels and these seemingly magical ratios can be used to predict price action — that is, “to predict with better than 50/50 coin flip” odds, which is all a trader really needs. They don’t tell the future or guarantee 100% winning trades, but they show you where price is likely to continue (rather than stop-and-reverse; more on this later.)
Fibonacci was named after Leonardo Fibonacci, a mathematician who discovered a number pattern that explains many of nature’s patterns, from spirals to the birth patterns of various species. None of that is really important to a Forex trader… except for the fact that the ratio between Fibonacci’s numbers is one of the most popular methods of projecting market corrections.
Does it really have anything to do with the patterns that naturally occur? Honestly, it doesn’t matter.
Whether you believe these patterns always occur because of some major formation of crowd psychology (some people actually believe that they occur in the markets just like they occur in nature) — or even if you believe that they’re nothing more than a self-fulfilling prophecy caused by the “market movers” — all that matters is that it works… more often than it doesn’t.
That’s right, I said it just works “more often than it doesn’t.” That’s really all I have to say about one of the methods that helps keep food on the table here.
That line may not sound as exciting as some of the Forex product ads you’ve seen before — because, well, the reality isn’t that overblown and exciting — sometimes, it can even be boring. But would you rather be making money, or getting an adrenaline rush? (Seriously, ask yourself this now before you waste thousands of dollars on an adrenaline rush.)
I’m not going to fill your head with dreams about a holy grail trading method because everyone who’s been around in this business for longer than a year already knows you can only find those in colorful Forex scam products (or so they claim anyway.)
The truth is: professionals just need tools that allow a trader to be right more often than wrong, in one way or another. In fact, many of us barely even need that to make money… as long as the method allows us to control our risk-reward balance. (I’ll get into that in the money management pages.)
WHY TRADE WITH FIBONACCI LEVELS?
Day after day, week after week, Fibonacci retracement and extension projections are used by individual and institutional traders alike. Yet, I’ve even heard a struggling trader claim that he ran a “test” that proved Fibonacci levels are no better than a coin toss for predicting future prices.
That may technically be true… but guess what: some of us are using it to grow our accounts at rates that hedge fund managers only wish they could (not because they can’t but because of other issues that I won’t bore you with here.) Why? Because we don’t always need to predict future prices to make money — it just helps to have a road map to where and when price is likely to continue (and where it’s likely to stall and reverse.)
So what’s so special about Fibonacci retracement and extension levels?
Every day, trillions of dollars change hands on the Forex markets — mostly in pairs like the GBP/USD, USD/JPY, and EUR/USD (in other words, the major Forex pairs.) Cue the record-scratch sound effect. You’ve probably heard this spiel a million times from online Forex brokers.
Yes, it’s true, but did you know that the great majority of those trillions of dollars are traded by a few major banks? (That’s “few”, compared to the millions of small banks around the world.) These major worldwide banking institutions, called Tier 1 banks in Foreign Exchange jargon, are essentially the hands that move the markets. Major Forex pairs like GBP/USD (British Pound vs US Dollar) and EUR/USD (Euro vs US Dollar), often touted as the most liquid pairs in the currency trading world, are essentially driven by the combined decisions of traders at the Tier 1 banks and the client orders that they put through.
In case you were wondering what I meant by “liquid” — that just means that there’s always someone out there to buy when you’re ready to sell, and vice versa. And now you know why.
Now, you might argue that these Fibonacci retracement and extension levels are really the result of all their client orders netted together to create a natural phenomenon… or maybe the Tier 1 bank traders themselves believe in these levels, and therefore cause them out of a self-fulfilling prophecy, as I mentioned in the introduction. You can choose to believe one or the other, it doesn’t matter as long as your belief doesn’t affect your trading decision making process.
What matters is that these levels provide us with something every trader wants: Predictions.
WHAT EXACTLY DO FIBONACCI LEVELS PREDICT?
You might be wondering: Do Fibonacci retracement levels tell me how far price will pull back? Will Fibonacci extensions tell me exactly where price will continue to?
Actually, no. And that’s actually not what we need them for.
See, the value of these price “zones” is that they give us a better than 50% chance that price will stall when if and when it reaches these zones. Allow me to emphasize that: if and when, not just when. We don’t need to know that price will for sure reach these levels in order to make profits. All we need to know is that, if the market pushes the price of a currency toward one of these “zones”, the highest odds of stalling is less on the way there and more when it actually reaches there. Neither one is a guarantee, just a better than 50% chance… and that’s all we need to make real money.
As I’m typing this, I feel like a lot of it comes across vague or generalized. I guess I just can’t explain every detail of every concept I mention in this introduction without branching off into a million tangents, so expect to see some detailed elaborations when I get around to them in the (more in-depth) pages on this site.
For now, all you need to know is that after the market has made a swinging move (in either direction), there are opportunities to use the Fibonacci retracement and extension levels to predict where it will most likely stall in the near future.
When would you need such a thing?
Well, imagine that you’ve already entered a trade going long (you bought, ie. you’re betting on its price going up) on GBP/USD. For the purposes of this example, it doesn’t matter how or why you entered, only that you already have. Now, one of your biggest problems might be that you’re worried you might take profits too early or too late. What if you hold on to your entire position and watch as it turns around and slams you into a losing trade. Or, worse, what if you take the entire trade off the table, only to watch as the market continues in your direction for another 5x your profit.
Using Fibonacci retracement and extension levels, you can better predict where price is more likely (more than 50/50 odds) to stop — and when price is nowhere near a level, you can place confidence (more than 50/50 confidence, of course) in the likelihood that price might still continue.
(In reality, I would never leave my profitable trades to chance as much as the above example implies. I’m just using that to illustrate the basic idea behind the use of these price “zones”. In a real world trade, there are other factors that could help us kill two birds with one stone. I’ll explain more in the strategy pages.)
It’s not a magic wand for Forex profits… but it’s one of the most invaluable tools in the arsenal of profitable Forex traders. It’ll help you make better decisions (or at least help you plan better profit targets for your trades.) Learn to use them.
Continue to Fibonacci Retracement Basics…
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