When participating in the forex market, the Fibonacci sequence is often used by investors to determine support and resistance levels. In addition, it is also used to set stop-loss orders and determine target prices. So what is Fibonacci? What does it mean? And what should you keep in mind when using this indicator? Let’s find out about Forex Trading in the article below.
What is the Fibonacci concept? Role in Forex trading
The Fibonacci sequence is a trading aid, not an exact prediction method. Effective use of this indicator series requires a combination of other technical indicators and careful market analysis. Below is an overview of this index.
Definition of Fibonacci numbers in forex trading
The Fibonacci sequence is a sequence of numbers created by adding two previous numbers to create the next number. Starting from 0 and 1, the sequence continues with 1, 2, 3, 5, 8, 13, 21, etc. The outstanding feature of this sequence is that the ratio between two consecutive numbers is approximately 0.618 (or called the golden ratio) and 1.618.
What benefits does Fibonacci bring to your trading?
Traders use the Fibonacci sequence plotted on the price chart. To identify potential support and resistance zones, take profit and stop loss levels. As well as predicting trend reversal points.
- Retracement levels: Common retracement levels include 23.6%, 38.2%, 50%, 61.8%, and 78.6%. These levels are considered points where prices can retrace from a sharp increase or decrease before resuming the trend.
- Extension levels: Additionally, traders also use Fibonacci extension levels. Includes 100%, 138.2%, 161.8%, 261.8% and 423.6%. These levels are used to predict potential targets for price after a breakout from a support or resistance zone.
- Entry and Exit Point Analysis: Traders often use them to identify potential buy and sell points.
Additionally, another indicator you can also use is Ichimoku. Ichimoku can also be used to identify trends, entry/exit points, and support/resistance levels similar to the Fibonacci number sequence. You can learn more to increase trading efficiency.
How is Fibonacci Retracement different from Extension?
Both Fibonacci Retracement and Extension are commonly used tools in Forex trading. However, these two indicators have different uses.
- Retracement (FR): Identify potential support and resistance areas after a price movement. FR is based on Fibonacci ratios to predict possible price retracements before the price continues its trend.
- Extension (FE): Identify potential price targets after the price breaks through the support/resistance zone. FE is also based on Fibonacci ratios, but instead of predicting prices to go against the trend, FE predicts prices will continue to move in the current direction with a larger margin.
In short:
- FR looks to the past to predict temporary stops.
- FE looks into the future to predict potential price points that prices could reach.
Therefore:
- FR is often used to enter orders or take profits when prices retrace to support/resistance levels.
- FE is often used to set a profit target after the price breaks through a support/resistance zone.
See more: Be more successful through this technical analysis
Instructions for entering orders and taking profits with Fibonacci
The Fibonacci sequence provides potential support and resistance levels, helping traders effectively. Below is a complete guide to help traders enter orders and take profits.
Use Fibonacci Retracement to enter orders
Fibonacci Retracement is a popular tool for identifying support and resistance areas after price movements. Here are the steps:
- Identify trends: Use trend lines or technical indicators to identify market trends.
- Draw Fibonacci Retracement: Use the Retracement from the peak to the bottom of the recent price movement.
- Identify support and resistance levels: Popular Fibonacci Retracement levels: 23.6%, 38.2%, 50%, 61.8%, 78.6%.
- Support level: In an uptrend, the Fibonacci levels can be supported, and the price can continue to rise after touching this level.
- Resistance level: In a downtrend, the Fibonacci levels can be resistance, the price can continue to decline after touching this level.
- Enter command:
- Buy: In an uptrend, when the price touches or retraces from the support level, you can enter a buy order.
- Sell: In a downtrend, when the price touches or retraces from the resistance level, you can enter a sell order.
For example: Suppose the price of EUR/USD is in an uptrend. Recently, the price increased from 1.1000 to 1.1500, then retraced to 1.1300.
- Draw the Fibonacci Retracement from 1.1000 to 1.1500.
- The 50% Fibonacci support level is located at 1.1250.
- When the price retraces to 1.1250 and forms a reversal signal, you can enter a buy order with the expectation that the price will continue to increase.
Apply Fibonacci Extension numbers for profit-taking
The Fibonacci Extension Indicator is a technical analysis tool used to identify potential price targets after price breaks through a support/resistance zone. It is based on Fibonacci ratios to predict what levels the price may reach before the price reverses. Below is a guide to using Fibonacci Extension for profit-taking.
Instructions on how to combine the Fibonacci sequence with the price channel to take profits
A price channel is a technical analysis tool used to identify price zones within which prices tend to trade. Price channels are often drawn with two parallel lines, one upper and one lower, based on recent price peaks and troughs. Combining the sequence with price channels can help you determine more effective profit-taking levels in Forex. Here’s how:
- Drawing price channels: Identify recent tops and bottoms. Draw two parallel lines connecting these points, one is the resistance line and the other is the support line.
- Drawing Fibonacci Retracement: Drawing from top to bottom of the price channel.
- Determine take profit level: Use popular Fibonacci levels such as 23.6%, 38.2%, 50%, 61.8%, 78.6%. Set a take profit target depending on the price trend and the location of the Fibonacci level relative to the resistance or support line.
- Use confirmation signals: Combine Retracement with other signals such as price patterns, technical indicators, or market news to confirm potential take profit levels.
Example: Suppose the price of EUR/USD is in an uptrend and is trading within a price channel. Recently, the price increased from 1.1000 to 1.1500, then retraced to 1.1300.
- Draw the price channel from 1.1000 to 1.1500.
- Draw Retracement from 1.1000 to 1.1500.
- The 61.8% Retracement level is located at 1.1438.
- When the price touches or retraces to 1.1438 and forms a reversal signal, you can take profits on part or all of your trading position.
Combine the Fibonacci sequence with support and resistance
In the case of a price channel, it is not possible to identify support or resistance zones. We can still choose the profit-taking point by observing the most recent important price zones before. Prices often tend to react to these important price zones. When meeting the support zone, the price will turn and go up. When meeting the resistance zone, the price will turn down.
Thus, any Fibonacci Extension level located near important price zones will be a more effective profit-taking level than other levels. For example, for the GBP/USD pair on the H4 time frame, after drawing the Fibonacci Extension, we observe neighboring price ranges in the past. There are two Extension levels located in important price zones:
- The level of 0.764 is at the bottom of the downtrend
- The level of 1,236 is within the bottom of the previous downtrend.
If you make a profit at 0.764, you still have a profit but not as much as the profit at 1.236. However, there is no guarantee that the price will go through the 1.236 level. The price may turn around before surpassing this price range. Therefore, if you identify many important price zones with strong resistance, you can take partial profits. For example, you can take a profit on half of the trading volume at the Fibonacci Extension level of 0.764 and the rest at 1.236. This strategy will bring you more profits.
How is the Fibonacci indicator combined with candlestick patterns used?
Fibonacci Retracement combined with Japanese candlestick patterns to find the reversal point of the correction. Similarly, the Fibonacci Extension combined with Japanese candlestick patterns also helps identify reversal points, but of the main trend.
The idea of this combination is that when a reversal candlestick pattern appears at a potential Fibonacci Extension level, there is a high possibility that the price will reverse, ending the main trend. This idea helps traders determine the most optimal profit-taking prices.
For example :
- EUR/USD on frame D1. When the price went up to level 0.764, the Tweezer Top reversal candlestick pattern formed. When this pattern ends, you should close the Buy order to make a profit. As a result, the price reverses, starting a new trend.
- AUD/USD on frame D1. When the price surpasses level 1.0, a Bullish Reversal Pin bar forms, it is predicted that prices will not fall further. At this time, you can take profit at the Fibonacci Extension 1.0 level. A bullish candle with a long lower shadow right after the pin bar candle increases the probability of a price reversal.
Is the Fibonacci extension safe?
Fibonacci Extension does not guarantee absolute safety. It can break for many reasons:
- Market volatility: Economic news and investor sentiment can cause prices to break out.
- Inaccurate swing analysis: Determining swing high and swing low points depends on each person’s analysis.
- Lack of combination with other indicators: Using the Fibonacci Extension alone can lead to inaccurate results. It should be combined with other indicators and analyze the market carefully.
Example of failed Extension in GBP/USD 4H chart:
- In case the price touches level 0.5 but then reverses: This shows that this is not a support/resistance level.
- Lack of confirmation signal: The price touching the Fibonacci Extension level is not enough to confirm an entry point. Additional confirmation signals are needed. Such as price patterns, technical indicators, or market news, to confirm the validity of the entry point.
Some disadvantages of the Fibonacci sequence that need attention
Some disadvantages to note about the Fibonacci number sequence in Forex trading:
- Determining swing high and swing low points to draw depends on each person’s analysis style. Leading to inaccurate investor analysis results.
- The price touching the level is not enough to confirm an entry point or profit target. Additional confirmation signals are needed, such as price patterns, technical indicators, or market news. To confirm the validity of the entry/exit point.
- The foreign exchange market is always volatile and influenced by many factors. Includes economic news, investor sentiment, and unexpected events. These factors can cause the price to break out, reducing the effectiveness of this tool.
- Using the indicator alone can lead to inaccurate results and losses.
- You need to have good trading knowledge and skills. Includes the ability to analyze price charts, use technical indicators, and effectively manage risk.
Some things to keep in mind before using Fibonacci
Although the Fibonacci sequence is useful for identifying support and resistance levels in trading. However, there will still be shortcomings in analysis that can lead to incorrect trading decisions. Therefore, investors need to note the following points:
- Do not use independent numbers. Combine with other tools such as support/resistance lines and moving averages. To avoid subjective and inaccurate judgments.
- Accurate determination of peak points. To ensure accuracy, it is necessary to determine the correct price levels and practice backtesting on many scenarios. As well as identifying tops/bottoms on multiple time frames.
- Be careful with reversals. Correctly evaluate trends and combine them with other tools to give accurate trading signals. Helps traders limit risks and increase their chances of success. At the same time, it can be applied in combination with Dow theory. Both tools assist in identifying market trends. Dow Theory helps identify primary and secondary trends, while Fibonacci provides potential support/resistance levels to identify trend reversal points.
See more: Optimize trading with IC Markets Exchange
Instructions for setting up Stop loss via Fibonacci extension
Here are instructions on how to set up Stop loss:
- Identify the trend: The first step is to identify the current trend of the market. You can use trend lines, technical indicators, or price analysis to identify trends.
- Determine the entry point: For example, the breakout point from the support/resistance zone.
- Draw Fibonacci Extension: Use the tool on the price chart. Drag the instrument from the entry point to the top (highest point) or bottom (lowest point) of the most recent price movement.
- Determine the stop loss level: Common levels include 100%, 138.2%, 161.8%, 261.8%, and 423.6%.
- Stop loss level: When the price is in an uptrend, you can set a stop loss level at one of the Extension levels lower than the entry point.
- Stop loss level: When the price is in a downtrend, you can set a stop loss level at one of the Extension levels higher than the entry point.
For example: Suppose you entered a buy order for EUR/USD at 1.1250 when the price broke out of the resistance zone.
- Draw Fibonacci Extension from 1.1250 to 1.1500 (most recent peak).
- Extension levels below 1.1250 include 100% (at 1.1250), 138.2% (at 1.1138), and 161.8% (at 1.1063).
- You can set your stop loss at one of these levels, for example, 1.1138 (138.2% level).
Conclude
Fibonacci is a powerful technical analysis tool used in Forex. Provides traders with multiple ways to determine potential entry and profit-taking points. However, it should be noted that Fibonacci is a probability tool and not an exact prediction tool. Take the time to research, practice, and combine it with other analytical tools. Don’t forget to follow Forex Trading to learn more important skills to help you make wise trading decisions and increase your success rate.
Frequently asked questions
What are the most important Fibonacci ratios in Forex trading?
The most important Fibonacci ratios in Forex trading include 23.6%, 38.2%, 50%, 61.8%, and 78.6%. These ratios are used to plot the Fibonacci Retracement and Extension levels.
Should I use Fibonacci Retracement or Extension?
Both tools have their advantages and disadvantages. Fibonacci Retracement is suitable for identifying potential support/resistance levels. While the Fibonacci Extension is suitable for identifying potential price targets. Both tools should be used together to increase trading efficiency.
How to manage risk when using Fibonacci in Forex trading?
Risk management is important in Forex trading, and so is it when using Fibonacci. To manage risk, set a stop loss order for each trade to limit losses. Start with a small capital. Do not trade all capital, reserve a part of reserve capital for unexpected situations.
