Trading Forex with Fibonacci (Part 1)

Specialty: FOREX
Tuesday, March 20, 2012

By Huzefa Hamid
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Huzefa Hamid, co-founder of the The Forex Room, gives an introduction to Fibonacci ratios and how to trade with them in part one of this
three-part article series.

I am very pleased to have been invited by DailyForex.com and MoneyShow.com to write this short course on Fibonacci. Together, we’ll

begin with the basics of Fibonacci and build on the concepts until we reach the stage of being able to plan trades. We’ll round off the course

by looking at actual trade examples, including some trades that I have taken myself.

These concepts will be applied specifically to the currency markets, but they work in any market. Anything that has price, supply, and

demand data can be analyzed and traded using Fibonacci ratios.

Part 1: The Fibonacci Numbers

So this is where it all begins: the “Fib numbers.” Leonardo Fibonacci was a 13th century Italian mathematician who made popular a simple

sequence of numbers that came to be known as the “Fibonacci Number Sequence”.

The sequence is this: starting with 0 and 1, each number is the sum of the previous two numbers. So after 0 and 1, the next number is 1,

followed by 2, followed by 3, then 5... you get the idea. The number sequence goes on forever, expanding to infinity:

13

21

34

55

89

144

233

377

610

987…

These numbers have some unique properties. Let’s take two consecutive numbers in the sequence: 21 and 34. If you divide one by the

other, 21/34, you get 0.618. If you take any other two consecutive numbers, for example, 144 and 233, and divide one by the other, 144/233,

again, you get 0.618. It doesn’t matter how far down the sequence you go, you will always arrive at 0.618 when you divide one number in the

sequence by the next one along.

This particular ratio, 0.618 (or 61.8%) is often referred to as “The Golden Ratio” because so many traders find it to be a strong area of

support or resistance on a chart.

Aside from 61.8%, there are other ratios present in the Fibonacci sequence. The next ratio is found by taking a Fibonacci number and

dividing it by the number two places along in the sequence. For example, if we pick 21, we would divide it by 55, which is two places along.

This gives 0.382 (or 38.2%). You would get 0.382 no matter which number you started with as long as you divide it by the number two places

along. So, 89 divided by 233 is again 0.382.

 Continuing with this idea, if you divide a Fibonacci number by a number three places along in the sequence, for example, 55 divided by 233,

you would get a new ratio: 0.236, or 23.6%.

So far, we have discovered three common ratios in the Fib number sequence:

1. 0.236, or 23.6%

2. 0.382, or 38.2%

3. 0.618, or 61.8%, also known as “The Golden Ratio”

This is all great; it’s an interesting idea, but where does it lead us in our journey as traders?

Trading Forex with Fibonacci (Part 1)

Specialty: FOREX
Tuesday, March 20, 2012

By Huzefa Hamid
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(Page 2 of 2)

The reason this series of numbers and its associated ratios are still being discussed centuries after first being widely known is because they

are found everywhere in nature, and today, they are found in the markets.

For example, the human body is built around these ratios:

From the foot to the navel, to the head, the common ratios of 0.236, 0.382, and 0.618 are found in the proportions of the human body.
The proportions of DNA strands are also in line with the Fibonacci ratios. So are the proportions of the moon to the Earth and even Saturn’s

rings. The Greeks, over two thousand years ago, used the Golden Ratio when designing the proportions of the Parthenon, as did the

Egyptians when calculating the size and height to build the Pyramids. Flowers more often than not have precise “Fib” numbers of petals,

such as varieties of daisies with 55 petals and 89 petals.

Given that Fibonacci ratios are present from the smallest in DNA to the largest in planetary systems, it’s no surprise that these same ratios

are seen in the way price moves in the market.

Let’s take a look at an example of price moving in harmony with The Golden Ratio. This is a daily chart of EUR/USD.

Click to Enlarge

The price moves from the major low at point 1 to the major high at point 2, then retraces 61.8% of that distance before moving off again to

continue the original upward trend.

What Ratios to Use When Trading

Aside from the three ratios discussed, there are other ratios that are used by traders (and also found in nature, for that matter). Three more

common ratios are as follows:

1. 0.786: Square root of The Golden Ratio

2. 0.886: Square root of 0.786

3. 1.618: Inverse of The Golden Ratio, i.e. 1 divided by 0.618

To summarize:

1. Fibonacci begins with a simple sequence of numbers, each number being the sum of the previous two
 2. Dividing consecutive numbers in the sequence, and numbers separated by one or two places, gives the common Fibonacci

ratios: 0.236, 0.382 and 0.618. The last ratio, 61.8%, is known as “The Golden Ratio”

3. These ratios are found in nature and are also found in the way price moves in a market

Tomorrow in Part 2, we’ll look at Fibonacci ratios and how drawing retracements of those ratios on a chart will help you find levels for profit

targets and stop losses on any trade.

Trading Forex with Fibonacci (Part 3)

Specialty: FOREX
Thursday, March 22, 2012

By Huzefa Hamid
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Huzefa Hamid of The Forex Room and DailyForex.com continues this three-part lesson on Fibonacci with a discussion of how to use the
88.6% Fibonacci retracement to spot profitable forex trades.
Yesterday (in Part 2) we looked at Fibonacci retracements and how you can use them to spot areas where price may turn. (Also read Part 1

here.)

In this series of articles, we have so far built up a foundation of Fibonacci as applied to trading: how the Fibonacci ratios are derived, how to

measure Fib retracements, and most recently, how to measure Fib extensions.

When Fibonacci is applied to trading, there are three common routes:

1. Using multiple retracements and extensions to find price levels where different Fibonacci levels coincide to produce “clusters”

2. Using additional indicators, for example, MACD, with Fib levels

3. Using Fibonacci levels as part of larger chart patterns; for example, a “head-and-shoulders” reversal pattern

Today, we’re going to discuss a particular Fibonacci level that I focus on much more and often trade in isolation: the 88.6% retracement.

To recap, the 88.6% level is derived by taking The Golden Ratio, 0.618, square rooting it and then square rooting it again to get 0.886.

Now, when I say, “This is an 88.6% Fibonacci retracement,” all that means is that the retracement is 88.6% of the size of the initial move. So

if the initial move was 100 pips up, the retracement would be 88.6 pips down.

Fibonacci levels do not have a bias for particular time frames: they have the same validity if you’re looking at a long-term weekly chart or a

short-term five-minute chart.

Let’s start off with a weekly chart of the US dollar versus the Swiss franc, or USD/CHF:

Click to Enlarge
The price firstly made a high at point X at 1.1967 on March 8, 2009. It then moved down to the low at point Y at 0.9909 on Nov., 22 2009. So

the price moved 2,058 pips over 37 weeks.

Then the price retraced to point Z at 1.1730 (or 1,821 pips) on May 30, 2010, i.e. 28 weeks after point Y. Looking closely at the chart and the

figures, the retracement was within two pips of the 88.6% level. This is incredible given that the price traveled thousands of pips over many

weeks and months, yet still made such a precise hit against a key Fibonacci level.

Identifying this level and seeing a clean hit could yield a trader in excess of 1,000 pips if he chose to ride the price down after the

retracement ended at point Z. (If you were to zoom out on the chart, you would also see that this set-up was part of a very long-term

downtrend for the USD/CHF which has, in fact, still continued to this day.)

Alternatively, knowing that a key Fib level had been successfully and cleanly tested, a trader could take multiple trades on shorter-term

charts such as four-hour or one-hour charts, looking for entries to sell USD/CHF. Entering on shorter-term time frames but using a long-term

level allows for tighter stop losses and better risk/reward ratios on your trades.

A potential target for your trades could either be the start of the retracement, point Y, or a 100% extension of the initial move, which would be

slightly beyond point Y.

Now let’s take a look at an actual trade I took on the GBP/USD on this 15-minute chart:

Click to Enlarge

I saw that the price had tested the 88.6% level, as marked by small blue line on the chart (this is what my chart actually looked like as I was

trading). However, I didn’t enter right away. The price had already moved quickly and I was concerned about where I would place my stop-

loss.
 Trading Forex with Fibonacci (Part 4)
Specialty: FOREX
Friday, March 23, 2012

By Huzefa Hamid
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Huzefa Hamid of The Forex Room and DailyForex.com continues his multi-part lesson on Fibonacci with a discussion of how to trade forex
using Fibonacci extensions.

This week we have covered the Fibonacci percentages starting from 23.6% to beyond 100%. We then defined a retracement and looked at

how the size of a retracement can coincide with a Fibonacci level on a chart. (Read Part 1, Part 2, and Part 3.)

To recap, the list of Fibonacci levels we covered were:

23.6%

38.2%

61.8% (The Golden Ratio)

78.6% (Square root of The Golden Ratio)

88.6% (Square root of 0.786)

100%
112.7% (Fourth root of 161.8%)

127.2% (Square root of 161.8%)

138.2% (Addition of 100% and 38.2%)

161.8% (1 divided by 0.618)

200%

261.8% (Addition of 100% and 161.8%)

Fibonacci Extensions

Now, we’re going to examine the move beyond the retracement, often known as an “extension,” and we will measure extensions using the

same Fibonacci levels.

By definition, the extension is often considered the third move, or “Wave 3” when looking at a chart. There is an initial move, a retracement,

followed by an extension, as in this five-minute EUR/USD chart:

Click to Enlarge

When measuring an extension in relation to Fib levels, we measure it in proportion to the first move. In other words, we look at the size of the

extension and see what that size is as a percentage of the first move (up to point 1 on the chart above).

This is not as straightforward as measuring the retracement, but with a little bit of practice, it should be easily understood. Let’s take a look at

the same five-minute EUR/USD chart:

 Click to Enlarge

For the sake of clarity, I have removed all other Fibonacci levels and just left one level displayed to prevent the chart from being too cluttered.

In this example, the 100% level is hit. What that means is that the size of the first move is equal to the size of the extension. In practice, the

size of the move up to point 1 was 154 pips, and the distance the price moved from point 2 to the end of the extension was 156 pips, i.e. a

fraction over 100%.

Let’s take a look at two other examples of extensions hitting different Fibonacci levels. In the following example of a daily GBP/USD chart,

the price moves up to point 1, retraces to point 2, then hits the 78.6% Fib extension level before moving back down again.

Click to Enlarge

Of course, extensions can be measured to the downside as well if that is the trend, as in this four-hour AUD/USD chart:
 Click to Enlarge

Here, the price moves down to point 1, retraces to point 2, and then hits the 78.6% extension level before moving back up.

As with retracements, multiple extensions can be combined on a chart, and this will be explored later in the series.

In summary:

1. The move after the retracement is known as an “extension”

2. An extension can be measured as a Fibonacci proportion of the first move, or wave 1

3. Multiple extension levels can be combined on a single chart

Note: MetaTrader refers to extensions as “expansions.” To measure extensions in MT4, go to “Insert > Fibonacci > Expansions.” Click and

drag the mouse on the screen to your desired points. Double-click anywhere on the handle line to move the start and end points using the

small square handles that appear. Right-click and go to “Expansion Properties” to change the Fib levels, change colors etc.