Fundamentals of the Forex Fibonacci Trading Strategy
What it is Forex? And how does it relate to the Fibonacci sequence?
Perhaps you are new to Forex trading and are looking forward to grasp the fundamentals, let’s have a brief look the concept of Forex in simple terms.
Forex, or foreign exchange, is a form of trade that thrives on a simple and yet surprisingly lucrative concept. Forex trading involves buying a currency at a particular price and then selling it later with the intent to earn profits. This type of trading takes advantage of the fluctuations that are associated with currency values. The forex market is volatile in the sense that currency values keep changing relative to each other due to various factors. For instance, the present value of the Euro relative to the US dollar is 1 Euro/1.12 dollars. In other words, 1 Euro is worth 1.12 dollars. However, due to a range of factors, you may find out that the Euro's value increases against the dollar in such a way that 2 weeks later, it becomes worth 3 dollars. This means that two weeks later, what the Euro was worth relative to the dollar, is more than what it was before. This provides a financial advantage in the sense that if a trader buys 50 Euros today, the same 50 Euros will be worth more dollars after 3 weeks thereby leaving the trader with a gain or a profit if he decides to convert the Euros to dollars.
You might have come across some intimidating abbreviation combinations like EUR/USD or USD/JPY. Well, these are known as forex pairs. A forex pair is basically an expression of how two currencies relate to each other in terms of value. For instance, EUR/USD represents how much the USD is worth for one Euro and the value is usually expressed to four dismal places due to the huge difference a small currency change may make in the overall value. Small changes in decimals may quickly add up to come up with a colossal impact at a large scale which may imply huge profit or losses.
However simple it may seem, Forex trading isn’t by any means a matter of simple guesswork with the ability to make your bank account more generous. Success is often a result of careful and calculated planning. Forex traders don’t just place bets and hope that the price fluctuation will be in their favor. There are tools and strategies that increase the likelihood of getting the right prediction which may translate into profits.
This takes us to the Fibonacci strategy as the most popular tool that traders use in both forex markets.
The Forex Fibonacci Trading Strategy
Fibonacci tool trading/Fibonacci formula trading uses the Fibonacci strategy which is aimed at providing foresight to the trader in order to increase chances of success in the future.
The Fibonacci strategy utilizes a form of technical analysis whose aim is to predict future fluctuations or exchange rate levels. The analysis uses what are known as retracement lines or levels which are plotted on forex chats to predict the future possibilities in terms of the value of one currency relative to another. Let’s have a look at a brief historical background to understand this easily.
Why Fibonacci anyway?
The strategy is based on a sequence of numbers that was discovered by Leonardo ‘Fibonacci’ Pisano in the year 1202. The sequence was described in one of his influential works in Mathematics called the Liber Abaci.
The Fibonacci sequence
The mathematical sequence follows a simple rule. It describes an infinite progression of numbers in which each number is the sum of the two numbers before it.
The numbers include: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610……
This sequence has a lot of applications in the real world as it has revealed a lot of relationships that are observed in different aspects of the world we live in. For instance, a further exploration of the sequence reveals a number called the Golden ratio which is 1.618 which can be expressed inversely as 0.618. You will notice that each number in the sequence is about 1.618 times the number before it. Mathematicians have come to establish that this number keeps appearing in a number of phenomena across the real world including biology, art, architecture and the natural world. In other words, it seems to be a constant number that is secretly imbedded in the laws of nature as it is observable in natural objects like tree branches, the human body, and the galaxy etcetera.
The Fibonacci Sequence and Forex
The Fibonacci sequence seems to extend beyond and has a special application in Forex. There is a series of numbers/ratios derived from the sequence that can be used in conjunction with forex charts showing relationships between currencies to predict future trends of the forex market.
These ratios are expressions of particular mathematical relationships of the numbers in the Fibonacci sequence, and they include: 38.2%/0.382, 23.6%/0.236, 61.8%/0.618. For instance, the first ratio (38.2%) is a constant number that comes up when you divide a particular number by the number which is two places to the right side whereas the 23.6% ratio comes up after dividing a Fibonacci number by the number occurring three places to the right side.
These ratios a plotted together with the forex charts to determine what are known as Fibonacci retracement levels. To be more precise, the key Fibonacci ratios are plotted to the left of the forex graph from where horizontal lines are drawn to intersect with the wave in the graph thereby establishing points which can be used to determine probable future trends of the graph lines. The horizontal lines are basically used to determine points where the trend is expected to take a particular direction, also known as reversal points.
These reversal points equip traders with the benefit of foresight as they can expect a particular direction the trend will take based on the plotted reversal points on the charts.
The 0.5/50% Retracement Level
Among the Fibonacci ratios, you will notice that most charts use 50% as one of the ratios. If you try to experiment around with the sequence, you will notice that it is not exactly a particular relationship between certain numbers of the sequence. The ratio should be considered as more of an exception in the key Fibonacci numbers on the charts because though it isn’t a particular relationship, its reversal point seems to be quite significant in most charts, and it is also an esteemed ratio in other mathematical theories including the Dows theory.
Fibonacci Retracements Levels and Forex Trading Strategies
Fibonacci retracements are an integral part of most trader’s strategies in today’s foreign exchange market.
In simple terms, after establishing the horizontal lines/Fibonacci levels, forex traders expect that the price graph is most likely to return/bounce back to the initial general trend upon seeing the wave reach the retracement levels.
There are two scenarios in relation to this case. A price wave usually takes an upward or downward trend. If the general trend is upward, though there may be a downward fluctuation somewhere in the middle, it is expected to return to an upward trend upon reaching a particular retracement level or horizontal line. In forex terms, the particular point at which the price reflects back to an upward trend is called a support. In the case of a downward trend, the specific point where an upward fluctuation reflects back to a downward trend is called resistance.
These retracement levels can be effectively used to determine the appropriate time or entry points to join the trade as one may have a high degree of confidence regarding the expected trend of the two currencies.
To illustrate the case, the chart image below displays a EUR/USD chart. The left side of the graph shows the Fibo ratios whereas the right side is showing the forex rates. At the bottom, you can see a time period starting from May to August. The graph is generally telling us how the USD faired against 1 Euro in a time period between May and August. The horizontal lines drawn from the Fibonacci numbers mark the retracement levels intended to be used as points where the price is expected to take a particular direction.
The general direction of the wave suggests that the rates took a downtrend from from May through to August. But a closer look will quickly reveal that somewhere in June, the trend changed and went upwards where another retracement took place at point C to resume the normal downward trend. If you take a look at the point C, you will notice that it is a Fibonacci retracement level at 38%.
Considering this scenario, traders would get into the trade at point C with the anticipation that the rates will resume the general downward trend that commenced earlier in May.
It is also important to notice that quite a number of traders would also be targeting the other ratios including the 50% and 61.8% which didn’t materialize.
Another great point to take home is that Fibonacci levels shouldn’t be the only indicator used to predict forex market trends. There are other tools that can be used together with the retracement lines that can help to reinforce the accuracy of ones prediction. These tools include candlestick patterns, trend lines, momentum Oscillators and moving averages. In general terms, if the Fibonacci predictions are in line with other prediction tools, the likelihood that the prediction is accurate is also high.
The concept of Fibonacci retracements is quite a handy method when it comes to making accurate predictions as it helps to establish reversal points of a particular trend in advance. However, it is also important to remember that there is always the chance that the trend may not abide by the Fibonacci prediction and take an unexpected trend. This necessitates the use of the sequence in conjunction with other indicators which can furnish a broader view of the likelihood of a particular trend.
Before we get into issues to do with the Fibonacci and its relationship to stock exchange, let us get into the basics of stock exchange first.
What Exactly is a Stock Market?
The term ‘stock market' is an umbrella term describing a group of markets and exchanges where the buying and selling of stocks or shares of companies, bonds and other forms of securities take place. The trading takes place in two main ways namely formal exchanges and over-the-counter exchanges. Likewise, securities exist in two man types which also determine the type of trading. Over-the-counter securities are traded in a direct manner between traders. The transactions are mainly done through dealer networks which are entities which facilitate the trading. Listed securities refer to those stocks which are traded on formal exchanges. Upon satisfying certain regulations, such as that of the Securities and Exchange Commission (SEC) and the associated exchange entities, these stocks are listed publicly. OTC securities can present the advantage of not having to go through SEC regulations, but this often comes with the common problem of not being able to find reliable information.
The great advantage that stock markets provide to the economy is that it provides companies with the opportunity to source out capital through providing investors the benefit of ownership.
The stock market can be broken down to two main sections namely: primary and secondary market. The primary market is basically where issues are sold initially through what are known as Initial Public Offerings/IPO.
Generally, the opening price of a particular company is determined by its worth and the quantity of shares being issued. The trading activity following the primary trading takes place in the secondary market which involves institutions and individual investors. However, when it comes to large companies, all trading takes place through formal exchanges rather than over-the-counter exchanges. Such exchanges exist around the world with the most famous and powerful stock exchanges being the New York Stock Exchange/NYSE, the London Stock Exchange and the Tokyo Stock Exchange.
The Fibonacci Strategy and Stock Trading
You might remember that earlier, we were talking about a special ratio based on the Fibonacci sequence called the Golden ratio (1.618). This ratio is known to express related proportions of almost everything in the natural world including the tiniest things like atoms to large scale bodies like the galaxy. The ratio's applicability to all components of nature has earned it the name ‘divine proportion'.
Just as we've demonstrated in the case of Forex, its easy to see that this ratio is also applicable in the financial world in the sense that these markets are also governed by the same natural laws that govern natural phenomena.
The stock market is no exception to the applicability of the Fibonacci sequence, in the sense that, the Fibonacci ratios can be used to predict price trends in the stock market. The use of the Fibonacci sequence in stock trading can also be referred to as Fibonacci series stock trading or Fibonacci lines stock trading.
Just like the case with forex charts, the stock market utilizes stock charts in which stock prices are plotted in relation to the Fibonacci levels/Fibonacci lines to establish reversal points which can be used to predict future trends in terms of stock prices. And again, Fibonacci retracements are not used in isolation here but they are used in conjunction with other indicators like the Elliot Waves to have a reinforced and more accurate prediction of the future trends. In fact, the Elliot waves also demonstrate patterns that exhibit proportionalities that conform to the Golden ratio.
Forex and stock trading continue to be influential drivers of economies in the 21st century, and through the unprecedented advancement of technology in the last few decades, they are rapidly becoming accessible to smaller entities and individuals. However, fully benefiting from these trading concepts implies having the right tools to fully exploit them, of which the Fibonacci trading strategy is part of. Mastering this approach often makes the difference between success and failure in both the Forex and stock markets.