Friday, June 19, 2009

Why it's important to understand Fibonacci retracement levels in Forex trading.

Leonardo of Pisa (c. 1170 – c. 1250) is known as Fibonacci [pronounced fib-on-arch-ee], a famous Italian mathematician. He figured out a pattern in the sequence of numbers, each number is the sum of the previous two numbers, starting with 0 and 1. Something like this:

  • 1+2=3
  • 2+3=5
  • 3+5=8
  • 5+8=13
  • 8+13=21
and so on. This pattern appears even across nature, like the structure of honeybee cells, musical notes etc. The ratio of two consecutive Fibonacci numbers numbers converges on the golden ratio (approximately 1:1.618) as its limit.

In technical analysis, Fibonacci retracement is created by taking two extreme points (usually a major peak and trough) on a forex chart and dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance levels.
Why is this important in forex? Because many traders use Fibonacci retracement levels to whether or not jump into a trade. It's like a self-fulfilling prophecy in stock trading. If you tell enough people to buy a stock from company X because you 'just know' the price will higher it eventually will go higher because there are enough buyers to drive the price of the stock up. This is the same with Fibonacci retracement levels in Forex trading since about 30% of traders swear by Fib levels.

Below is an excellent example on how to apply Fibonacci retracement levels on a chart.

As you can see, understanding and adding those levels is relatively simple, but it can help you place more accurate trades. Of course, as recommended in the video, it's wise to apply this to your own trading strategy.

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