An introduction to Fibonacci trading

Leonardo Fibonacci (fi-bo-NA-chie) was an Italian mathematician of the thirteenth century. Among his many achievements was the introduction of the Hindu-Arabic numeric and decimal system, as used today throughout the world, to the European continent. He also first introduced an Indian numerical sequence to Europe, and this series of numbers today bears his name.

A simple explanation of the Fibonacci series of numbers is that each number is the sum of the two preceding ones. Each number is approximately 1.618 times greater than the preceding number, and comprises approximately 0.618 of the succeeding one. The series goes:

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233

and so on. Fibonacci numbers can be used to describe many patterns in everyday life, including the growth rings of sea shells, the petals and seedheads of flowers, the arrangement of leaves growing around a plant’s stem, the formation of pinecones and pineapples, and the growth patterns of human beings, among many other examples.

Without going into more complicated mathematics, the important percentage points in Fibonacci numbers are: 0%, 23.6%, 38.2%, 50%, 61.8%, 100%, and 161.8%.

In forex trading, Fibonacci ratios are used as a leading indicator to predict price action. Often, a currency pair will set a strong trend, only to retrace a percentage of its path prior to resuming the original trend. These so-called retracements and extensions tend to follow Fibonacci ratios.

Below is a screen shot of the hourly chart for NZD/USD, taken at 7:17 AM GMT on 12 November 2007, showing an almost textbook example of a Fibonacci retracement.

The trend began at 0.7865 on 7 November at 17:00, and slid to 0.7674 on 8 November 09:00. It then retraced to 61.8% of its original price, or 0.7791, on 9 November 03:00 and consolidated there for several hours before resuming its original trend, falling past the point where it began the retracement and extending to the 1.618% point at 0.7557 and even a bit below that.

As leading indicators in forex trading, Fibonacci ratios do not reflect what a currency pair’s price has done in the past, as lagging indicators such as MACD and all moving averages do, but rather indicates the anticipated pattern for the future. This is obviously advantageous to the forex trader, and many profitable trades have been made using Fibonacci swings.

The classic Fibonacci trade is to place an entry order at the 61.8% level, to enter the market when the retracement ends and the extension begins. In the example of the NZD/USD above, the entry point is around 0.7785. The stop-loss is at the 0% point, which is the beginning of the original trend, in this example 0.7865; this can be a trailing stop to lock in profits once earned. The take-profit point is the expected extension limit, usually 1.618%, or of course whenever the trader is satisfied with the trade.

An interesting note is that many extensions become secondary Fibonacci swings. Note on the chart above that, after reaching the extension limit (a trend), the currency pair began a retracement. Experienced forex traders will watch that to note if it reaches a Fibonacci percentage then extends again, offering another profitable Fibonacci trade.