A Guide To Using A Fibonacci Retracement For Better Trade Setups | Forex Trading Strategy

By Ekzaga Staff

24 October 2018 2:38 pm


 

Many beginner traders get confused when going through the certain functions/indicators on Metatrader 4 or TradingView. When your starting out on your trading journey, it’s common to question why we use certain trading tools. It can take up to days and even weeks to learn, understand, use, analyse and implement them as part of a trading strategy. Many traders make a substantial profit from just trading major/minor support and resistance levels. The key to trading success is to use any particular tool with consistency.

 

Origins 

The Fibonacci Retracement term stems from the great Mathematician, Leonardo Fibonacci. He was born in Italy in 1170 and was well known for his mathematical work. It was known widespread that Fibonacci found the connection and significance to the sequence of numbers mentioned below while studying the Great Pyramid of Giza in Egypt.


Fibonacci numbers are derived from a series of numbers where for each two former consecutive numbers give the total of the next number 1 ,1 ,2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, etc. (1+2=3, then 3+5=8 etc.). These numbers have a fascinating number correlation whereby if the two number adjacent in the series are divided by each other e.g. 8 by 5 & 21 by 13 etc. it will give a number close 1.618. Or we can explain it as each number in series after 3 is approx. 1.618 times then previous number or any allotted number is around 0.618 times the following number. 1.618 is referred as to the golden mean ratio and the miraculous nature of this number is prevalent in all forms of nature, historic buildings/architecture and even ancient art.


Although in reality when we actually dissect and understand the Fibonacci retracement tool most of the times its only referred to as having the all-important level 0.618 or 61.8% level. Retracement is usually referred as correction i.e. trade entry is based on price correction. There are more key levels to the Fib retracement other than the 61.8 level. Just to note the purpose of this article is to focus on Fibonacci Retracement however there are four Fibonacci tools in total. These are the Arc, Fans, Retracements, and region of Time.  
 

What does a Fibonacci Retracement look like?

Fibonacci Retracement is a series of support and resistance levels at key tested levels. Different platforms like Metatrader4/5 and TradingView have different default pre-sets. Majority of platforms have the above levels i.e. 0%, 23.6%, 38.2%, 50%, 61.8%, 78.6% and 100% (these are normally standard). You may see levels of 123.6%, 161.8% etc. which are classed as fib extensions and are used for further profit targets. 


These levels can be removed on the settings option for the Fibonacci tool (MetaTrader4/5 or TradingView). You normally draw the tool onto a chart then right-click to edit the parameters.


The 0 and 100% levels are integral points when drawing the fib retracement tool. We are going to show examples of how the 61.8% and 50% level are effective levels for price correction and how it can be used within a strategy for entry and take profit (closing out a trade).

 
To additionally benefit from the Fibonacci strategy, it’s good to have some knowledge of candlestick patterns. When you can spot a certain candlestick pattern around a fib level it serves as an additional powerful signal for an entry.

 

How to Draw a Fibonacci Retracement?

 

The key to drawing a Fibonacci Retracement is to identify an adequate rally either bullish or bearish. As shown above, the black arrow suggests a bullish rally on a daily chart for GBPUSD.


Just to mention, a Fibonacci Retracement tool can be drawn on any time frame and is effective all the way to 1min chart. This is one tool that is universally used by all types of traders e.g. Scalping, Day Trading, Swing Trading and Long-term.

Rules for drawing:

 

  1. The 0 to 1 (100%) levels should be drawn from one point to the other point of a rally
  2. It should be drawn exactly from the wick (shadow) of a candlestick i.e. not from the body of candlestick
  3. Make sure you have all your fib levels set i.e. mainly 50% and 61.8%

 

Using Fibonacci for Entering a Long trade

 

 

As you can see from the above illustration this is typical setup of Fibonacci Retracement on the daily chart for GBPUSD. A Fibonacci retracement should not be used on its own but in conjunction with other tools such as Support/Resistance analysis, Candlestick formation, High & lows trend analysis, Top-down, moving averages indicator etc. Use it to give you a more accurate trade setup. 


In the above illustration, the blue rectangular bar represents previous major support. It’s a strong support indicated by the red arrows to the left. Price tried to break that level on two occasions but then eventually it broke creating a new low in price. 
 

Entry

Your mind-set at this particular stage is wait for the new low to be created. The new low was created on the 14th August. From then on the price of GBPUSD reversed in a bullish stance. The next obvious sign was price moving back to the blue rectangular box indicating that previous support will be the new area of resistance level. Once price test the new resistance level it bounces off for a correction phase. 


During the beginning of the correction phase a Fibonacci retracement has to be drawn from 0 to 1 (100%) shown above from one point to the other point of the rally. Please remember it has to be drawn from 1 to 0 (e.g. in the image the bottom of rally is at 100% (1) and the 0 at the top of rally. As price is correcting/retracing then you have to pay attention to the 50% level or 61.8% (or 0.5 or 0.618 level mentioned above).


It is completely up to you as an individual which Fibonacci level you trade from. You could place a buy limit order at 50% and have your stop loss level well below the 61.8%. Please note you must stay within the guidelines of your risk management rules. A lot of traders only trade off the 61.8% or 0.618 Fibonacci level as a more conclusive entry point.
 

Exit

As mentioned in previous articles. Knowing when to exit a trade is as important as where to enter. Closing a trade to early means less profits. With the Fibonacci tool it’s very easy to place an exit or close out level. As shown in the GBPUSD chart above, the exit level will be the 0% level. The green arrow indicates that a profit of 234 Pips would be made and you would place and take-profit/exit level at 0% of Fib level. 

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