Guide to the Fibonacci indicator in Forex trading

Technical trading relies on chart and candlestick patterns, technical indicators and simple trendlines. Learning how to conduct a technical analysis is essential for every trader. Even if you are a purely fundamental trader and only study economic and political events, technical trading will help you find the best entries and exits.

Fibonacci indicator for Forex is free to use and accessible through most trading platforms.

Spotting significant levels where price is likely to bounce or reverse trend is critical for technical traders. Traders enter trades from significant levels, which enables them to place tight stops and get great risk to reward ratios. Let’s dive deep to find out more about this indicator and its uses.

Fibonacci indicator overview

• The “golden ratio” is the centerpiece of the Fibonacci indicator, which is used across many asset classes, such as stocks, forex, crypto, commodities, etc
• The Fibonacci retracement levels are 23.6%, 38.2%, 61.8%, 78.6%. It’s worth mentioning that 50 is not a Fibonacci number, however, 50% level is actively used in the FX trading Fibonacci indicator
• The Fibonacci retracement levels are plotted on the price chart
• The Fibonacci lines can be drawn between any two significant price points on a chart. Traders join two extreme points of a price swing to get Fibonacci retracement levels
• The percentage levels show points where the price may reverse, or bounce
• Fibonacci is a leading indicator that is used to forecast possible retracement points
• Forex trading Fibonacci indicator can be used alongside oscillators, moving averages, momentum, and volume indicators

Technical details of the Fibonacci indicator in Forex

Fibonacci is one of the most versatile indicators used in Forex trading. However, it is not advisable to rely solely on the Fibonacci levels to make trading decisions. Before looking at the practical applications of the indicator, it is important to consider the origin and technical characteristics of the Fibonacci sequence and the retracement/extension indicators.

Fibonacci sequence definition and meaning

The Fibonacci sequence is a mathematical pattern that appears in nature in various forms. The sequence was first observed in the 12th century and has various applications in the modern world. One of which is finance,

In trading, the Fibonacci sequence describes the relationship between waves within price trends, which is useful in identifying retracements, breaks and reversals on the market.

The sequence consists of integers, with each corresponding number being equal to the sum of the two numbers that come before the prior number in the sequence.

Fibonacci retracement level indicator

The primary indicator derived from the Fibonacci sequence in trading is the Fibonacci retracement level indicator.

The indicator is presented as lines plotted on a price chart that indicate the percentage levels that correspond with the Fibonacci sequence and show support and resistance levels for the asset in question.

The most commonly used Fibonacci levels are 23.6%, 38.2%, 61.8%, 78.6%. While not officially a Fibonacci level, the 50% mark is also used. The retracement indicator can be drawn between any two price points that are deemed relevant by the trader. Period highs and lows are often used as reference points for the retracement levels.

Fibonacci time zones

Fibonacci time zones are another type of indicator rooted in the Fibonacci sequence. The indicator is typically placed on a major high or low swing on the price chart. The Fibonacci time zone is a leading indicator and vertical lines are placed to the right to indicate the possible times when a reversal, or another significant swing, could take place. The lines are based on the Fibonacci sequence.

The time periods correspond with Fibonacci numbers, which means that the indicator would assume the upcoming swings to be the same distance away from the starting point as the Fibonacci numbers are away from 1. It must be noted that the time zones are not concrete indicators of major swings, and the first five zones are typically dismissed due to their proximity to the starting point. The time zones work well with support and resistance points. When the price is approaching the support zone, as well as one of the Fibonacci time zones, and the price starts to pick up past the support zones, this confirms the support level.

It is important to understand that Fibonacci time zones are concerned with time periods and not the price of the asset.

Fibonacci extensions

The Fibonacci extensions are used to determine how far the price may move after a pullback has concluded. The common Fibonacci levels used in extensions are 61.8%, 100%, 161.8%, 200% and 261.8%.

The indicator uses three price points:

• The first price point is selected at the start of the move
• The second price point is selected at the end of the move
• The third point is at the retracement against the move

Much like retracements, Fibonacci extensions do not have a formula and are represented as dotted lines on a price chart. To find the Fibonacci extensions:

• Multiply the difference between the two reference points and multiply the difference by the difference ratio to obtain a dollar amount
• When expecting the price to move higher, add the dollar value to the third price point. Conversely, subtract the dollar value from the third price point when expecting a downward movement

Fibonacci extensions are used to create price targets and support and resistance levels when support and resistance are not as evident on the chart.

Forex trading using Fibonacci

Fibonacci indicator for FX traders is a versatile tool that can be deployed to suit many trading strategies, some strategies are more commonly used than others. Some of the most frequently used Fibonacci trading strategies that do not rely heavily on other indicators are:

• Buying at the 50% level and placing a stop-loss order somewhere slightly below the 61.8% level
• Buying at the 38.2% level and placing a stop-loss order slightly below the 50% level
• When a retracement happens just below one of the Fibonacci levels, but the price resumes moving in its prior direction shortly after, the higher Fibonacci levels of 161.8% and 261.8% can be used to identify possible future support and resistance levels

Analysis using Fibonacci

The Fibonacci levels can be useful in analyzing the historical trend and price changes experienced by the asset in question. The price levels identified by historical analysis can also be useful in the short term, which can be convenient, as the Fibonacci indicator is best suited for medium to long timeframes. This is especially true in the forex market, as the price ranges derived from historical data can remain relevant for extended periods of time on the forex market, due to the preconceived expectations of market participants.

This can be an important tool for long-term traders and investors on the forex market, as the sentiment of market participants usually alternates within the boundaries of psychological price levels.

Pros and cons of using Fibonacci

Advantages:

• Pivot point determining accuracy – With the correct setting, they can quite accurately determine the moments of price reversals at early levels or confirm a change in the trend direction at later levels
• Versatility – The tool can be used on assets of any market and any timeframe. However, there is a caveat: the higher the timeframe, the more accurate the signals. Although Fibonacci is a favorite tool of scalpers working on MT4 and MT5, the price noise can cause errors
• Accurate display of market psychology – Most of the technical indicators are based on a formula that reflects the patterns of previous periods. Fibonacci levels are built on both a mathematical algorithm and the psychology of the majority – this can be taken into account when building a Fibonacci trading system

Disadvantages:

• Difficulty of determining the starting point – A trend is never perfectly flat. Even at the moment of exiting the flat, it is sometimes difficult to determine the starting point
• False signals – They can happen when using this tool and there are quite many of them. And these signals are not so much false as inaccurate. The price can turn around without reaching the level or after breaking it and turn around in the middle of the zone
• Cannot be used in Expert Advisors – It is impossible to write an automatic grid building algorithm into the EA code. Therefore, the tool cannot be used in algorithmic strategies

Pitfalls to avoid

While Fibonacci may be a versatile indicator that is widely used in the trading of different asset classes, the indicator is not a one size fits all solution to generating buy and sell signals on the market. Here are some common pitfalls to avoid when using the Fibonacci indicator:

• Fibonacci retracement levels use two price points as reference. Using different reference points can make the indicator seem confusing and lead to misleading conclusions, which render the indicator obsolete. Being consistent with the reference price points is essential in using the indicator effectively
• Ignoring long term trends can be detrimental to any forex trading strategy. Traders must keep in mind that no price point or chart pattern can exist in isolation, and is always a part of a wider trend. Keeping track of the long term trend formations can help traders place the Fibonacci retracement levels by using the most relevant price points as reference
• Simply relying on Fibonacci alone will not be enough for formulating a profitable forex trading strategy. Luckily, Fibonacci is a versatile indicator that goes well with most momentum and volume indicators out there. Some notable indicators include: Bollinger Bands, the Relative Strength Index (RSI), the Moving Average Convergence/Divergence (MACD), etc
• Using Fibonacci on very short time frames may not be so effective. When day trading, the market can seem exceedingly volatile – and it is. The Fibonacci retracement levels need some price data to remain effective, which is hard to come by when traders are placing hundreds of orders each day

Practical application of the Fibonacci indicator in forex

Now we can look at the Fibonacci indicator example by plotting it on the EUR/USD price chart. For reference, we will also look at the indicator used alongside the RSI and MACD, as well as the combination of Fibonacci and Bollinger bands to make for a hybrid technical indicator.

EUR/USD

The 1-month EUR/USD chart shows the Fibonacci retracement levels plotted on the chart. The first levels are very tight, while each new level increases the distance. The image shows the price sandwiched between the first and second Fibonacci levels. The chart also gives insight into the past price points, when the pair was below parity. The same level is shown as being below the sixth Fibonacci level, which would indicate that the probability of the pair reverting to the same level around 0.97 would be quite low.

With MACD

Adding the moving average convergence/divergence to the Fibonacci chart introduces a daily simple trading strategy. The MACD measures the strength of the trend through convergence and divergence, while the Fibonacci shows support and resistance levels.

To use the MACD with Fibonacci, the following strategy could be applied:

• When the signal line crosses above the MACD line while the price crosses above or below the last Fib level – traders can buy
• hen the signal lie crosses below the MACD line when the price crosses above or below the last Fib level – traders can sell

The first scenario indicates upward momentum due to the signal line crossing above the MACD line, while in the second scenario, it crossed below the line – indicating a slowing trend.

With RSI

The RSI is another indicator that can be used to confirm the Fibonacci retracements. To combine the two in a single strategy, certain prerequisites need to be met:

• Use Fibonacci to identify the support and resistance levels
• Use the RSI to gauge when a turn could occur
• Enter the trade with a 1:2 or higher risk/reward ratio

When the price crosses above a Fibonacci level, but the RSI shows a divergence, this is a good signal to enter the market, as the divergence shows a slowing momentum. The price is making higher highs, but the RSI is making lower highs, which indicates that the momentum of the trend will not last much longer. When the price breaks lower, traders can place a stop-loss order and a take-profit at least twice the distance away from the stop-loss to obtain at least a 1:2 risk/reward ratio.

Fibonacci Bollinger Bands

The Fibonacci Bollinger Bands is a combined indicator that functions similarly to the regular Bollinger Bands. The key difference is that each band of the Fibonacci Bollinger Bands is a Fibonacci ratio of the average true range away from the baseline. This makes the Fib Bollinger Bands a versatile instrument due to its flexible support and resistance curves. Fibonacci BB uses the ATR instead of moving averages, which makes the indicator more responsive to sudden price changes.

History and other useful details of the Fibonacci indicator

The Fibonacci sequence is a commonly observed mathematical phenomenon that is seen in art, nature, architecture, etc. The sequence is named after Leonardo Fibonacci, a 12th century Italian mathematician, despite the fact that the sequence was discovered centuries before and was widely used by Indian mathematicians.

In the sequence, each number is equal to the sum of the prior two numbers. The Fibonacci consists of integers and is an infinite sequence.

The Fibonacci numbers are 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 and so on, with the sequence continuing indefinitely.

FAQs on the Fibonacci indicator in Forex trading

Is Fibonacci a good indicator?

The Fibonacci retracement level indicator is a popular technical tool that uses the golden ratio in identifying support and resistance levels for an asset’s price. Fibonacci is a highly versatile indicator that works well with most oscillators and volume indicators available to traders.

Does Fibonacci indicator work in trading?

Fibonacci is one of the most widely used and well-regarded technical indicators in Forex trading. However, there are some common pitfalls that traders need to be aware of to use the indicator effectively. One of such pitfalls is using only the Fibonacci indicator without adding other technical tools to the mix.

Is using Fibonacci indicator expensive?

The Fibonacci indicator is free and readily available when signing up with a Forex broker. The indicator itself is not technically complex and demanding, which makes it highly popular.