First a little history lesson to understand better what Fibonacci actually is. The inventor of Fibonacci is Leonardo of Pisa, an Italian mathematician in the thirteenth century, the son of Bonaccio which in Italian is "Filius Bonnacio" hence by contraction resulted Fibonacci.
Fibonacci represents a sequence of numbers where the first number is 0, the second number is 1, and each number after equals the sum of the previous two numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34 etc. The interesting part in this sequence is the mathematical relations between these numbers expressed as ratios. Try dividing any number in the sequence by the one after it and you will discover what it is known in trading as the "Golden ratio" which is 61.8%.
Example:
8 divided by 13 equals 0.61538
13 divided by 21 equals 0.61904
21 divided by 34 equals 0.61764
As the sequence progresses the value comes closer and closer to 0.618. If you try dividing any number by the number coming two places further to the right you will discover another ratio 38.2% (13 divided by 34 equals 0.38235). Another important Fibonacci ratio is 23.4%.
So what's this got to do with Forex trading? For some strange reason these ratios play an important role in trading. If you study price movements you will discover that very often previously established trends are likely to continue after retracing to one of these levels. For example EUR/USD moves from 1.3820 to 1.4160 and than retraces to 1.3950 (which is 61.8% retracement of this move). At that point price is rejected and it continues its original uptrend.
Forex traders also like to use the 50% retracement but this has nothing to do with the Fibonacci ratios. Combine this knowledge with obvious support and resistance points in the market or pivot points and you can discover great entry points for your Forex trades.
Another important addition to your trading tools is the Fibonacci extensions which are used to predict an extension of a move after it retraces to a Fibonacci level. Studies demonstrated that retracements to the 38.2 level predict an extension of 1.618% to 200%,a 50 % retracement predicts an extension of the move to 1.382%-1.618% and lastly a retracement to 61.8 level predicts an extension ranging from 100% to 121.4%. Retracements that go beyond 61.8% are less likely to revert.
Again combine the Fibonacci extension theory with pivot points rejections and you can determine an optimum profit target for your Forex trades. More details about pivot points rejection in a future article.
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