How to Profit from Fibonacci Retracements in Forex

Fibonacci Retracements are probability points where a currency, or stock will "bounce back" to, after a large move, and then continue in the original direction. Think of Retracements in terms of Newton's Laws of Motion: "For every action there is an equal and opposite reaction."

Within this understanding, trading carries some of the same principals. However, I would like to add that after a large move, the opposite reaction loses energy quickly, and thus, is often why the 'reactive move' after a large move, is often less than the large move itself.

Ironically, Leonardo Fibonacci lived in the 13th century, while Newton worked in the 17th century. Perhaps Fibonacci unknowingly uncovered truth behind Newton's laws, centuries before Newton even came up with them.

Fibonacci in Nature

If you're not familiar with Fibonacci ratios and numbers the concepts are directly derived from nature and are found in virtually all organic sciences today. Basically, Fibonacci numbers are resultant from adding the previous together to find the next. For example 1+1=2, 2+1=3, 3+2=5, 5+3=8 and so on. The Fibonacci string would look like: 0,1,1,2,3,5,8,13,21,34,55,89,144,233...

In nature, the spiral of seeds in a sunflower are exactly ordered in Fibonacci sequence, as with many occurrences in organic life.

Fibonacci ratios are also derived from the numerical sequence. For example, if you take any eighth number in the sequence and divide it by the number following it in the sequence (dividing the eight by the ninth), the answer will ALWAYS be 61.8. In the above string, if we divide the eighth number (21) by the ninth (34), we get 61.76, or 61.8 rounded up.

It just is, that's why.

Market quants hold that Fibonacci is not only true in organic matter, but within the market itself, and Fibonacci ratios, more often than not, lay out of a map for retracement levels, after a significant move. Thus, perhaps Newton's Law of Motion that says, "For every action there is an equal and opposite reaction" failed to take into account the loss of energy in reaction, something that may be solved with Fibonacci ratios. I believe there would be another factor involved though, which may be overcome combining the founder of quantum physics Max Karl Ernst Ludwig Planck's formula, where "energy is and absorbed in quantities divisible by discrete 'energy elements'" and simple Fibonacci.

Perhaps someday I will make an attempt to prove my instincts in math. Before I get sidetracked (which is way too easy) any further though, let's look into how you can - very simply - use Fibonacci Retracements in Forex trading.

Fibonacci in Forex - The Self Fulfilling Prophecy

All of the magical math in the world will never make Fibonacci retracements true 100% of the time. Period. Thus, a little common sense goes a long way when using any type of mathematical, or technical indicator to trade from. If the market is showing something different than the indicator, enough people believe in something different that the indicator is wrong. Fibonacci retracements are only good so long as enough people are watching and acting on the same information that the collective whole makes the occurrence a self-fulfilling prophecy. What I'm saying is that even if you've opened a trade based on Fibonacci retracement expectations, be prepared to close the position, should common sense warrant such.

With the aforementioned in mind, Fibonacci Retracements work on both short and long-term time frames for all types of traders. For this article, we will only look at short-term trading with 4-hour charts.

First, before we even consider a Fibonacci retracements, you need to be able to spot when a move has occurred that would warrant using Fibonacci Retracements. This can be as simple as looking at a chart, and visually seeing that a large move has transpired - and capitulated. What I mean by this is, if when looking at a chart you're expecting to see empirical proof that a move has stalled, you will never be able to do so. You will see some signs, like MACD or Stochastics bottoming out, or a candlestick pattern like a hammer bottom, but you will never know for sure. One way to have a slight bit of assurance though, is to look for candlestick confirmation, something I recently covered in my article Why Confirmation Counts.

Regardless, only countless hours of pouring over charts will give you 'the feel'. Once you are able to infer a move is over, you can begin to apply Fibonacci retracements for profit targets points if you are trying to trade the rebound, or for new entries, if you are waiting to get back into the currency, for a continued move in the same direction, as the previous 'large move.'

The below chart shows a significant move that recently occurred when the U.S. dollar sold off against the Swiss franc. Based on this chart, many traders were likely looking for a retracement. Some turned the dollar long, others waited for key retracement levels to be hit before taking positions.


Now, let me show you how you can trade a 'reversal' using Fibonacci, after a large move.

In the below chart, you will see a large downward move, where the Australian dollar declined significantly against the New Zealand dollar. Several indicator (not shown) displayed that a reversal was looming, thus perceptive traders would have taken a long position in the Australian dollar, using the low of the range as a stop. The AUD quickly rebounded, touching the 38.2 retracement within 12 hours of the low. However, it sold off again (twice actually) before making another run at the 50% retracement. Jittery traders would have been shaken out for sure; however, those with steadfast stops just below the low of the original moves would have not. (You must decide for you whether you will trade for larger moves, or quickly scalp profits any time the market makes a sudden moves. It is my experience that traders who take small profit after small profit and cannot hold for larger wins, eventually get killed when they take a bigger loss. Truly great traders know one of the keys to success is: little loss, little loss, big win, not vice versa.)


Regardless, those who were able to hold, would have seen the AUD/NZD briefly pop above the 50% retracement a few days after the initial move occurred. Here's one way to solve the problem previously shown by failure at the 38.2% retracement. When trading a reversal, set your stop as soon as you make the trade. Then, set a sell order for one quarter of your position at the 38.2% Fibonacci retracement, so if the trade fails, you will have a small buffer when your stop is hit on the downside. (You will need to adjust the position size in your stop, if the 38.2% retracement is hit, accounting for the 25% of your position you just sold for a profit.) At the same time you made the initial trade, set a sell order for 50% of the total initial position at the 50% retracement. In the case of AUD/NZD, when the pair first hit the 50% retracement, you would have taken even more off the table…and would need to adjust your stop order accordingly, as you will now only have 25% of the original position. Then, with the remaining 25%, you can set another order to sell at the 61.8% retracement, or let it ride. FYI, from my experience trading Forex, the 50% retracement mark seems to hold the most weight, If a pair does not reverse the bounce after the large move, and you see a 4-hour bar close above the 50% retracement, there's a good chance the pair will retrace the whole move. I'm not sure why, but from what I've seen the 61.8% retracement seems to hold less weight than the 50% retracement, at least when using 4-hour charts.

Regardless, the retracements serve as profit targets for reversal trades.

For traders who think the pair will continue the original move, you can place your orders at the Fibonacci retracement points, where you hope to reenter in the direction of the big-move trend. One way to do so is place an order for 25% of your total predetermined size at the 38.2% mark, 50% at the 50% mark and 25% at the 61.8% mark… This way, you've allowed yourself 'wiggle room' if the 38.2% and 50% retracements do not hold. It's important to note though, that if the 61.8% retracement is breached, the pair will likely retrace the entire move, something that happens often in Forex trading. The best rule of thumb in this case is as simple as the old market saying: When in doubt, get out.


Sources :

1. How to Profit from Fibonacci Retracements in Forex Trading

By:
Mark Whistler is the founder of www.WallStreetRockStar.com and is the author of multiple books on trading. Mark's newest book, The Swing Trader's Bible - co-authored with CNBC/Fox News regular guest Matt McCall - will be on shelves in late summer, 2008. In addition, Mark also writes regularly for TraderDaily.com and Investopedia.com.