LeTechs Forex Blog - How Can You Use Fibonacci As A Leading Indicator?

20 Feb

How Can You Use Fibonacci As A Leading Indicator?

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Fibonacci sequence

The discovery of this phenomenon is credited to the 13th-century mathematician, Leonardo Fibonacci. The Fibonacci sequence is a series of numbers that seem to consistently occur in nature
Fibonacci method to calculate the sequence is to add any Fibonacci number together with the number that immediately precedes it in the sequence.
Assuming the first two numbers are F0 (Zero) and F1 (One), you can calculate the first ten numbers in the Fibonacci sequence as follows:

0 + 0 = 0

0 + 1 = 1

1 + 0 = 1

1 + 1 = 2

2 + 1 = 3

3 + 2 = 5

5 + 3 = 8

8 + 5 = 13

13 + 8 = 21

21 + 13 = 34

Therefore, the first ten numbers in the Fibonacci sequence are: The number 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181, 6765, 10946, 17711, 28657, 46368, 75025, 121393, 196418, 317811, 514229, 832040, 1346269, 2178309, 3524578, 5702887, 9227465, 14930352, 24157817, 39088169,...
The number of petals on flowers is often aligned with Fibonacci numbers; especially 3, 5 and 8. Black- some Daisies have 13 and 21 petals.

Fibonacci Ratios

From the Fibonacci sequence comes a series of ratios, and it is these ratios that are of special significance to traders.
The most important Fibonacci ratio is 61.8% - it is sometimes referred to as the "golden ratio" or "golden mean" and is accepted as the most "reliable" retracement ratio.
The Golden Ratio is arrived at by dividing any number in the sequence by the number that immediately follows it. No matter which number you choose, the answer will always be very close to the mean average of 0.618, or 61.8%. For example:

8 divided by 13 = 0.615 = 61.5%

13 divided by 21 = 0.619 = 61.9%

21 divided by 34 = 0.617 = 61.7%

The other two Fibonacci Ratios that fx traders use are 38.2% and 23.6%. These two ratios seem to have a lower level of success but are still included for analysis purposes.
The 23.6% ratio consists of any number in the sequence divided by the number that is three places to the right:

5 divided by 21 = 0.238 = 23.8%

34 divided by 144 = 0.236 = 23.6%

6765 divided by 28,667 = 0.235 = 23.5%

In a similar fashion, the 38.2% ratio is derived by dividing any number in the sequence by the number found two places to the right. For example:

8 divided by 21 = 0.380 = 38.0%

144 divided by 377 = 0.381 = 38.1%

6765 divided by 17,716 = 0.381 = 38.1%

In addition to these three ratios, most trading systems also show retracement levels at 73.6%, 50% and 100%.

How Should I draw The Fibonacci Retracement Trend Line?

The most important thing to know is that the base of the trend line if there is a bullish (up) trend should be drawn from left to right. You're currently noticing a retracement to the downside then you had wanted to look for support at one of the levels appearing on the chart. Consider currently a bearish (down) trend should be drawn from right to left and a retracement is taking shape than you had wanted to look for resistance.

How to apply important Fibonacci levels?

An important note about using any trading technical methodology is that neither you nor I can guess with perfect accuracy a future market move. So the next best thing is to watch closely levels of support and resistance. Once you notice a strong move off of resistance in a downtrend or support in an uptrend then you can use further levels of support as price targets in an uptrend, as well as resistance as price target in a downtrend.

GBPUSD Daily chart (Looking for Resistance)

USDCAD Daily chart (Looking for Support)

Fibonacci Projection Rules

First and foremost, you want to focus on trading in the direction of the trend of the chart you are trading on. The weekly trend may vary from the trend on the daily chart, but if you're trading on the daily chart than that is the trend you should be focusing on.

Fibonacci Price Extensions

EURAUD H4 chart

An easy way to think of Fibonacci extensions vs. Fibonacci retracements is that extensions go beyond 100% with the same tool used to find retracement levels. To find an extension level on a new uptrend, you would run the high to low extensions for possible resistance. Reversely, on a new downtrend, you would run the low to the high extension for possible support that can act as profit targets. The levels most commonly used are the 1.00%, 1.272%, 1.618%, 2.00% or 2.618%.

Closing Thoughts

Fibonacci Expansions and Extensions can be the great leading indicator of price targets once a Retracement level is honored. Deciding which tool to use is a personal choice for price targets as both methods have their benefits. Because this tool is taking you into new price territory, trailing stops are recommended along with the proper trade size so that your risk is always contained.