Every foreign exchange trader will use Fibonacci retracements at some point in their trading career. Some will use them just some of the time, while others will apply them regularly. But no matter how often you use this tool, what's most important is that you use it correctly every time.
Improperly applying technical analysis methods will lead to disastrous results, such as bad entry points and mounting losses on currency positions. Here we'll examine how not to apply Fibonacci retracements to the foreign exchange markets. Get to know these common mistakes and chances are you'll be able to avoid making them—and suffering the consequences—in your trading.
Key Takeaways
- A Fibonacci retracement is a reference in technical analysis to areas that offer support or resistance.
- The Fibonacci numbers come from an Indian mathematical formula which Western society named for Leonardo Fibonacci, who introduced the concept to Europe.
- One common mistake traders make is confusing reference points when fitting Fibonacci retracements to price action.
- New traders tend to take a myopic approach and mostly focus on short-term trends rather than long-term indications.
- Fibonacci can provide reliable trade setups, but not without confirmation, so don't rely on Fibonacci alone.
1. Don'tMix Reference Points
When fitting Fibonacci retracements to price action, it's always good to keep your reference points consistent. So, if you are referencing the lowest price of a trend through the close of a session or the body of the candle, the best high price should be available within the body of a candle at the top of a trend: candle body to candle body; wick to wick.
Incorrect analysis and mistakes are created once the reference points are mixed—going from a candle wick to the body of a candle. Let's take a look at an example in the Euro/Canadian dollar currency pair. The figure below shows consistency. Fibonacci retracements are applied on a wick-to-wick basis, from a high of 1.3777 to a low of 1.3344. This creates a clear-cut resistance level at 1.3511, which is tested,then broken.
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The figure below, on the other hand, shows inconsistency. Fibonacci retracements are applied from the high close of 1.3742 (35 pips below the wick high). This causes the resistance level to cut through several candles (between Feb. 3 and Feb. 7), which is not a great reference level.
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By keeping it consistent, support and resistance levels will become more apparent to the naked eye, speeding up analysis and leading to quicker trades.
Fibonacci retracements are based on the so-called Fibonacci numbers, introduced to the Western world by Leonardo of Pisa in 1202. Although they are named after an Italian, they were actually discovered by Indian mathematicians hundreds of years earlier. Their first known use was around 200 B.C. by the poet Pingala, who used them to classify the meters of Sanskrit poetry. Another Indian mathematician, Virahanka, provided the formula for their calculation about 600 years before Fibonacci.
2. Don'tIgnore Long-Term Trends
New traders often try to measure significant moves and pullbacks in the short termwithout keeping the bigger picture in mind. This narrow perspective makes short-term trades more than a bit misguided. By keeping tabs on the long-term trend, the trader can apply Fibonacci retracements in the correct direction of the momentum and set themselves up for great opportunities.
In the figure below, we establish the long-term trend in the British pound/New Zealand dollar currency pair is upward. We apply Fibonacci andseeour first level of support is at 2.1015, or the 38.2% Fibonacci level from 2.0648 to 2.1235. This is a perfect spot to go long in the currency pair.
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But, if we take a look at the short term, the picture looks much different.
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After a run-up in the currency pair, we can see a potential short opportunity in the five-minute timeframe (above). This is the trap.By not keeping to the longer-term view, the short seller applies Fibonacci from the 2.1215 spike high to the 2.1024 spike low (Feb. 11), leading to a short position at 2.1097, or the 38% Fibonacci level.
This short trade does net the trader a handsome 50-pip profit, but it comes at the expense of the following 400-pip advance. The better plan would have been to enter a long position in the GBP/NZD pair at the short-term support of 2.1050.
Keeping in mind the bigger picture will not only help you pick your trade opportunities, but will also prevent the trade from fighting the trend.
3. Don'tRely on Fibonacci Alone
Fibonacci can provide reliable trade setups, but not without confirmation.
Applying additional technical tools like MACD or stochastic oscillators will support the trade opportunity and increase the likelihood of a good trade. Without these methods to act as confirmation, a trader has little more than hopefora positive outcome.
In the figure below, we see a retracement offof a medium-term move higher in the Euro/Japanese yen currency pair. Beginning on Jan. 10, 2011, the EUR/NZD exchange rate rose to a high of 113.94 over almost two weeks. Applying our Fibonacci retracement sequence, we arrive at a 38.2% retracement level of 111.42 (from the 113.94 top). Following the retracement lower, we notice the stochastic oscillator is also confirming the momentum lower.
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Now the opportunity comes alive as the price action tests our Fibonacci retracement level at 111.40 on Jan. 30. Seeing this as an opportunity to go long, we confirm the price point with stochastic,which shows an oversold signal. A trader taking this position would have profited by almost 1.4%, or 160 pips, as the price bounced off the 111.40 and traded as high as 113 over the next couple of days.
4. Using Fibonacci for Short-Term
Day trading in the foreign exchange market is exciting, but there is a lot of volatility.
For this reason, applying Fibonacci retracements over a short timeframe is ineffective. The shorter the timeframe, the less reliable the retracement levels. Volatility can, and will, skew support and resistance levels, making it very difficult for the trader to pick and choose what levels can be traded. Not to mentionin the short term, spikes and whipsaws are very common. These dynamics can make it especially difficult to place stops or take profit points as retracements can create narrow and tight confluences. Just check out the Canadian dollar/Japanese yen example below.
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In the above figure, we attempt to apply Fibonacci to an intraday move in the CAD/JPY exchange rate chart (using three minutes for each candle). Here, volatility is high. This causes longer wicks in the price action, creating the potential for misanalysis of certain support levels. It also doesn't help that our Fibonacci levels are separated by a mere six pips on average,increasing the likelihood of being stopped out.
Remember, as with any other statistical study, the more data used, the stronger the analysis. Sticking to longer timeframes when applying Fibonacci sequences can improve the reliability of each price level.
Correctly Using Fibonacci for Forex
Fibonacci analysis is useful for forex traders to identify hidden support and resistance levels. There are two ways to apply Fibonacci methods to the forex market: Historical analysis and trade preparation. The first examines long-term trends in the forex market to identify the levels that trigger major trend changes.
The second method is used to anticipate the levels of retracement or recovery for forex prices. In this case, traders will place a Fibonacci grid over the chart of recent short-term price action, marking the various Fibonacci levels. They will then place additional grids over shorter and shorter time intervals, looking for places where the harmonic levels converge. These price points have the possibility of becoming turning points for price actions.
As with other forms of technical analysis, longer-term trends tend to be stronger than short-term ones. In other words, a support level on a weekly chart tends to be more reliable than one on a daily chart.
What Is the Main Disadvantage of the Fibonacci Method?
Although Fibonacci retracements can sometimes be used to predict price movements, many traders find the calculations too complex and time-consuming to use. Another disadvantage is that the results are too difficult for most traders to understand easily. Some experts believe that the Fibonacci levels have more to do with herd psychology than any innate property of the Fibonacci levels. As a result, traders should consider the possibility that the Fibonacci method is actually self-fulfilling.
Which Are the Best Fibonacci Retracement Settings?
The most commonly-used Fibonacci retracement levels are at 23.6%, 38.2%, 61.8%, and 78.6%. 50% is also a common retracement level, although it is not derived from the Fibonacci numbers.
How Accurate Are Fibonacci Retracements?
Some experts believe that Fibonacci retracements can forecast about 70% of market movements, especially when a specific price point is predicted. However, some critics say that these are levels of psychological comfort rather than hard resistance levels.
The Bottom Line
As with any specialty, it takes time and practice to become better at using Fibonacci retracements in forex trading. Don't allow yourself to become frustrated—the long-term rewards outweigh the costs. Follow the simple rules of applying Fibonacci retracements and learn from these common mistakes to help you analyze profitable opportunities in the currency markets.
