Mark Whistler is the founder of www.WallStreetRockStar.com and is the author of multiple books on trading. Mark's newest book, The Swing Trader's Bible - co-authored with CNBC/Fox News regular guest Matt McCall - will be on shelves in late summer, 2008. In addition, Mark also writes regularly for TraderDaily.com and Investopedia.com.
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Getting straight to the meat, Fibonacci Retracements are probability points where a currency, or stock will "bounce back" to, after a large move, and then continue in the original direction. Think of Retracements in terms of Newton's Laws of Motion: "For every action there is an equal and opposite reaction."
Within this understanding, trading carries some of the same principals. However, I would like to add that after a large move, the opposite reaction loses energy quickly, and thus, is often why the 'reactive move' after a large move, is often less than the large move itself.
Ironically, Leonardo Fibonacci lived in the 13th century, while Newton worked in the 17th century. Perhaps Fibonacci unknowingly uncovered truth behind Newton's laws, centuries before Newton even came up with them.
Fibonacci in Nature
If you're not familiar with Fibonacci ratios and numbers the concepts are directly derived from nature and are found in virtually all organic sciences today. Basically, Fibonacci numbers are resultant from adding the previous together to find the next. For example 1+1=2, 2+1=3, 3+2=5, 5+3=8 and so on… The Fibonacci string would look like: 0,1,1,2,3,5,8,13,21,34,55,89,144,233...
In nature, the spiral of seeds in a sunflower are exactly ordered in Fibonacci sequence, as with many occurrences in organic life.
Fibonacci ratios are also derived from the numerical sequence… For example, if you take any eighth number in the sequence and divide it by the number following it in the sequence (dividing the eight by the ninth), the answer will ALWAYS be 61.8. In the above string, if we divide the eighth number (21) by the ninth (34), we get 61.76, or 61.8 rounded up.
It just is, that's why.
Market quants hold that Fibonacci is not only true in organic matter, but within the market itself, and Fibonacci ratios, more often than not, lay out of a map for retracement levels, after a significant move. Thus, perhaps Newton's Law of Motion that says, "For every action there is an equal and opposite reaction" failed to take into account the loss of energy in reaction, something that may be solved with Fibonacci ratios. I believe there would be another factor involved though, which may be overcome combining the founder of quantum physics Max Karl Ernst Ludwig Planck's formula, where "energy is and absorbed in quantities divisible by discrete 'energy elements'"* and simple Fibonacci.
Perhaps someday I will make an attempt to prove my instincts in math… Before I get sidetracked (which is way too easy) any further though, let's look into how you can - very simply - use Fibonacci Retracements in Forex trading...
Fibonacci in Forex - The Self Fulfilling Prophecy
All of the magical math in the world will never make Fibonacci retracements true 100% of the time. Period. Thus, a little common sense goes a long way when using any type of mathematical, or technical indicator to trade from. If the market is showing something different than the indicator, enough people believe in something different that the indicator is wrong. Fibonacci retracements are only good so long as enough people are watching and acting on the same information that the collective whole makes the occurrence a self-fulfilling prophecy. What I'm saying is that even if you've opened a trade based on Fibonacci retracement expectations, be prepared to close the position, should common sense warrant such.
With the aforementioned in mind, Fibonacci Retracements work on both short and long-term time frames for all types of traders. For this article, we will only look at short-term trading with 4-hour charts.
First, before we even consider a Fibonacci retracements, you need to be able to spot when a move has occurred that would warrant using Fibonacci Retracements. This can be as simple as looking at a chart, and visually seeing that a large move has transpired - and capitulated. What I mean by this is, if when looking at a chart you're expecting to see empirical proof that a move has stalled, you will never be able to do so. You will see some signs, like MACD or Stochastics bottoming out, or a candlestick pattern like a hammer bottom, but you will never know for sure. One way to have a slight bit of assurance though, is to look for candlestick confirmation, something I recently covered in my article Why Confirmation Counts.
Regardless, only countless hours of pouring over charts will give you 'the feel'. Once you are able to infer a move is over, you can begin to apply Fibonacci retracements for profit targets points if you are trying to trade the rebound, or for new entries, if you are waiting to get back into the currency, for a continued move in the same direction, as the previous 'large move.'
The below chart shows a significant move that recently occurred when the U.S. dollar sold off against the Swiss franc. Based on this chart, many traders were likely looking for a retracement… Some turned the dollar long, others waited for key retracement levels to be hit before taking positions...
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