I've got something a little different for you today because the article below is a guest article from John Robinson (forextraders.com). It's a detailed article about fibonacci analysis and how you can incorporate it into your forex trading. I don't discuss this subject very often on this blog so hopefully you will find it useful.
Who knew that a mathematical theory developed sometime in the 13th century would have so many applications today? Leonardo Fibonacci, the Italian mathematician for whom the Fibonacci theory is named lived between 1175 and 1250, but his theory lives on today. In fact, Fibonacci is one of the most often used technical analysis tools by traders of all asset classes, but its applications when it comes to forex analysis are especially useful.
Understanding the Fibonacci theory is easy. It states that each term in a sequence of numbers is the sum of the previous two numbers. (1,1, 2, 3, 5, 8 and so on.) The sequence isn't all that important to understanding Fibonacci for forex analysis, but the power of the so-called Golden Ratio is. The Golden Ratio is basically the quotient of the adjacent terms and that number is 1.618 or 0.618 as an inverse. How important is this number? Just type Fibonacci 1.618 into a search engine and watch how many results turn up that involve the practical application of this number.
But enough with that. How can Fibonacci be used to make a forex trading strategy more profitable? Used in forex analysis, Fibonacci's golden ratio is translated to three numbers 38.2%, 50%, and 61.8%. Five lines are drawn on a chart including these three numbers with 100% and zero percent. Obviously, 100% is the high and zero percent is the low.
The interesting thing about the Fibonacci levels on a forex chart is that they frequently act as places where prices start to rebound or as support and resistance levels. On a traditional five-line Fibonacci chart, a currency pair that has retreated from the 100% line is likely to find support at the 61.8% line. If the pair doesn't find support there, that is a signal for to sell it short. Knowing this, it's fair to say the Fibonacci theory is a useful tool for trend traders.
On the other hand, Fibonacci can also be a profitable tool for short term trading. If scalping is part of your forex trading strategy, then you should not be without Fibonacci charts on your trading platform. As we said above, Fibonacci levels often represent price areas where a forex pair starts to rebound, so using the example above of currency that has peeled back from the 100% Fibonacci line, it is likely to find support at the 61.8% line and start to move higher again. If you take a look at a long-term chart, say an hourly or daily, and draw Fibonacci lines, you're bound to see several examples of the Fibonacci lines acting as areas where a previous price trend started to reverse.
The point is that short-term traders are often getting thrown around by market movements because they don't properly identify the most important price levels in a given forex pair. Proper use of Fibonacci lines can help prevent this problem and put the odds in favor of the forex trader. And no, you won't need to draw the lines yourself by hand. Most charting packages come with a Fibonacci feature.
Smart forex traders know that trading against the trend is perilous to the health of their account and that their forex analysis regimen needs to include trend identification. Fibonacci is a superior tool for keeping a forex trading strategy on the right side of the trend.
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