Lesson 6 – Fibonacci Retracements

Written on 10 November 2008 by Rod

Fibonacci numbers were developed by Leonardo Fibonacci, when he saw that these specific numbers were present all throughout the galaxy.

Fibonacci numbers are a series of numbers that when you add the previous numbers you come up with the next number in the sequence. Here is an example:
1+1 = 2
2+1 = 3
3+2 = 5
5+3 = 8
8+5=13

And so on like this:
1, 2, 3, 5, 8, 13, 21, 34, 55…

There are basically are four popular Fibonacci studies: arcs, fans, retracements, and time zones, being the Fibonacci Retracements the most widely used in Forex Market.

When a market is moving swiftly in a given direction, it may sometimes “retrace” or pull back as market participants take their profits. This phenomenon is known as retracements and will usually create good opportunities to re-enter the market at attractive levels before the move resumes.

Retracements are often of proportional sizes so it does not matter how long or strong the trend is. The retraces usually occur at 38.1%, 50% and 61.8% levels.

Actually, the 50% level really does not have anything to do with Fibonacci, but traders use this level because of the tendency of prices to reverse after retracing half of the previous move. So having said this, the 50% level is more a psychological level.

In the folloing example e illustrate in a very general way, a retracal to the 38% level in an uptrending market:

When a move starts to reverse the 3 price levels are calculated (and drawn using horizontal lines) using a movements low to high. These retracements levels are then interpreted as likely levels where counter moves will stop.

After a price makes a move to the upside (A), it can then retrace a part of that move (B), before moving on again in the desired direction (C). These retracements or pullbacks are what traders want to watch for when initiating long or short positions.

Once the price begins to pull back or retrace, then you can draw these retracement levels on your trade station or chart to look for candlestick reversal patterns or other reversal signals.

In the following example,we find a perfect retracement from point “A” to point “B” (at the 61.8% level) and then continues upwards toards “C” in an uptrending market.

In the following example, we find a retracement in a downtrending market, from point “A” to point “B1″ (at the 50% level) and then and then it continues down but retraces and stops again at the “B2″ point. Here is the importance of support and resistance levels. We can se that a trade con be confirmed with a double top at point “B1″ and “B2″ and a Fibonacci Retracement at the 50% level and a reversal candlestick pattern. So from here we are left with a high probability of a trade continuing strong towards a downtrending market towards point “C”.

Please note that you do NOT automatically buy the price just because it is at a common retracement level. A trader should always wait and search for candlestick patterns to develop at the 38.2% area. If you do not see any signs of a reversal, then it may go down to the 50% area. Look for a reversal there. And if that at this level you still do not find any other reversal pattern or confirmation, you would go to the 61.8%. Still at this level, you should confirm your reversal pattern with other indicators, because a change of trend could be occurring.

You do not know with certainty when the prices will reverse at a Fibonacci level. This is why you should mark these areas on a chart and wait for a reversal signal to take your long or short position.

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