Fibonacci retracement levels are the only thing I use outside of price action in my trading. Although the Fibonacci retracement is arguable a derivative of price action patterns as it uses swing highs and swing lows to calculate retracement levels.
But before we get too involved in the details, let’s first talk about where Fibonacci levels came from.
The Godfather of Fibonacci Retracement – Leonardo Fibonacci
Fibonacci retracement levels were discovered by an Italian mathematician by the name of Leonardo Fibonacci in the thirteenth century. Yes, Fibonacci levels have been around that long.
Leonardo Fibonacci had his “Aha!” moment when he discovered that a simple series of numbers that created ratios could be used to describe the natural proportions of things in the universe. What kinds of “things” you ask? All kinds!
Many traders don’t realize that Fibonacci levels have been around far longer than the Forex market itself. In fact the series of numbers that Mr. Fibonacci discovered were used in everything from studies of the universe to defining the curvature of naturally occurring spirals, such as those found in snail shells and the pattern of seeds in flowering plants.
Yes, you read that right – snail shells and flowering plants.
So what is this series of numbers that he discovered? I’m glad you asked…
The Foundation of Fibonacci Retracement Levels
Unlike many Forex trading tools out there, the secret behind Fibonacci retracement levels is extremely easy to understand. This is because the levels are simply a derivative of a series of numbers.
The Fibonacci sequence of numbers is as follows:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.
If you notice, each number in the sequence is the sum of the preceding two numbers. So if we broke this down it would look like the following…
0+1=1
1+1=2
2+1=3
3+2=5
5+3=8
etc.
This pattern continues infinitely. At this point you may be asking why this is so special. Well, for starters each number in the sequence is approximately 1.618 times greater than the preceding number. So although the numbers are different, they all have this common characteristic.
For anyone familiar with Fibonacci retracement levels, you know that 1.618 is extremely important. For those who are not familiar with Fibonacci levels, let me explain further.
The 1.618 number is called the “golden ratio” or “the golden mean”. It’s found by dividing one number in the series by the number that follows it. For example 5 / 8 = 0.625.
So now that we know where the 61.8% ratio comes from, let’s discuss the other two ratios that make up the Fibonacci retracement levels.
The 38.2% ratio is found by by dividing a number in the series by the number two places to the right. Here’s what that would look like using the Fibonacci sequence above.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.
So 13 / 34 = 0.382. Notice that all I did was take the number 13 and then divide it by the number that’s two places to the right, which is 34.
Last but not least is the 23.6% ratio. This Fibonacci ratio is found by dividing a number in the series by the number three places to the right. For example.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.
So 13 / 55 = 0.236 Notice how this is very similar to finding the 38.2% ratio, only this time we are using the number three places to the right instead of two places to the right.
So there we have it, the three Fibonacci retracement ratios. To recap we have the 61.8% ratio (called the “golden ratio”) the 38.2% ratio and the 23.6% ratio.
The Magic Behind These Ratios
So what is it that makes these ratios so special? To be honest, it’s still unclear. All that we know (traders and mathematicians alike) is that these ratios seem to play an important role in nature as well as the Forex market.
We can therefore use these Fibonacci ratios to help identify levels where a market may reverse. It’s important to remember, however, that these levels are only suggestions of where a market might reverse. It’s not recommended to trade these levels without a confirming price action signal.
Fibonacci Retracement Levels in Action
Now that we have a good understanding of where Fibonacci retracement ratios come from, let’s take a look at how these levels line up on a chart.
The first thing to know is that Fibonacci retracement levels are most effective when used at major swing highs and lows. I have also found these levels to be most effective on the higher time frames.
So let’s see how these Fibonacci levels line up on a GBPUSD daily chart…
In this example the swing high was used as the starting point and the swing low as the end point. If you’ll notice, the market respected the Fibonacci ratios fairly well.
In addition to the ratios we discussed above, many Forex traders also like to use the 50% level. Although not a true Fibonacci ratio, there is a common tendency for a market to continue in a certain direction once it completes a 50% retracement. Therefore the 50% level has been added to most Fibonacci retracement tools.
Summary
Fibonacci retracements are an incredible phenomenon in trading and nature alike.
However, like any trading tool, Fibonacci should never be used alone. It’s most useful when paired with other techniques.
It’s usually best to use these retracements to help confirm support and resistance levels and add confluence to certain areas.