Pattern recognition is an important skill that you should develop if you plan to actively trade the financial markets. A pattern is a repeated number of prices that can be recognized and has a discernable outcome. Prices patterns are formed in ranges and price trends, which can help you determine the future movement of a currency pair. One way that you can determine if prices are forming a pattern is to use the Fibonacci sequence. This mathematical pattern occurs in nature and is reflected in the movements of currency pairs. These types of patterns can help you enter a position or refine your risk management. The Fibonacci retracement is a very popular technical analysis charting tool that is pre-programmed into the MT4 charting packages offered by Rakuten Securities Australia.
What are the Fibonacci Numbers
A Fibonacci sequence is a group of numbers that were discovered by a 13th-century mathematician. The numbers reflect the spiral of a snail shell as well as other natural shapes. The number creates a ratio that is driven by the Fibonacci sequence. The sequence and therefore the ratio is the calculations that are used to formulate support and resistance levels generated from price movements. The most popular use of the Fibonacci sequence is the Fibonacci retracements which are available on MT4. The retracement levels can be used in conjunction with other technical analysis tools. Additionally, the Fibonacci ratios have been used to form other theories that describe the future direction of the price of a currency pair.
The Golden Ratio
The person who discovered the Fibonacci ratios was named Leonardo Pisano Bogolla. This Italian mathematician found a sequence of numbers that followed a specific pattern. Each number, starting with the third number in the sequence is the sum of the prior 2 numbers. For example, 2+1 is 3, and then 3+5, equal the next number which is 8. The sequence is 1,2,3,5,8,13,21 etc… These numbers also create a ratio. The ratio is the source of the Fibonacci retracement levels. If you divide the subsequent number by the current number you get a ratio of 1.618. If you divide the current number by the two numbers ahead of it in the sequence, the result is .382.
What are Fibonacci Retracements?
The most common use of the Fibonacci sequence is the Fibonacci ratios. These ratios are used to determine the likely targets when a currency pair is rebounding from a decline in its value or an increase in its value. The two most common ratios are the 32.8% ratio and the 61.8% ratio. A retracement is calculated by looking at the prior decline or rise in a currency pair and multiplying that value by 32.8% or 61.8%. The MT4 trading platform that is offered by Rakuten Securities Australia will do this calculation for you, but if you want to do it on your own, you would at the retracement value to the low after a decline or subtract it from the high after a rally to determine the target retracement.
You can see that the EUR/USD has rebounded during 2020 to the first Fibonacci retracement level which is the 32.8% rebound. This was calculated by measuring the decline from the high in early 2018 to the low in the EUR/USD currency pair in 2020. The first target is 1.367. This is likely a target where you might see a consolidation after a rebound from the lows in the EUR/USD currency pair during the Q1 of 2020.
Usually, when a currency pair hits a Fibonacci level it consolidates. The currency pair will either fail at these levels or begin to move higher testing the next levels of retracement. While the 32.8% and the 61.8% retracement levels are the most popular, the 50% retracement is also often used to target resistance or support levels.
Fibonacci retracements are constructed by connecting the peak to the trough or the trough to the peak. You will then multiply the change by 61.8% and 38.2% to target the most popular retracement levels.
Using Fibonacci on Different Time Frames
You can use the Fibonacci retracements on any timeframes, including daily, weekly, monthly, or intra-day charts. It is helpful to either use a bar chart or candle chart which has an open, high, low, and close, but you can also use a line chart that has closing points only. The Fibonacci ratios will work on all time horizons.
Using Fibonacci Retracements for Risk Management and Trading
You can use Fibonacci retracements to determine support and resistance levels which can help you entry and exit points. Your target levels could act as take-profit points or stop-loss levels. For example, if you decided to short the EUR/USD at 1.13, you might use the 32.8% retracement of 1.367 as your stop loss level. Alternatively, when the exchange rate passed through the 38.2% level you might target the 61.8% Fibonacci level as your take profit level.
Key Take Away
Fibonacci numbers were discovered by an Italian mathematician in the 14th century and are used in several different technical analysis applications. The most popular are the Fibonacci retracements. The Fibonacci numbers are created from a sequence of numbers that comprise the golden ratios which are used to calculate target retracements after a rally or decline in the value of a currency pair. You can use these levels to formulate entry and exit criteria as well as support and resistance levels. Traders commonly use Fibonacci retracements as part of their risk management criteria.
The ratios that are consistently used to formulate a 38.2% ratio and the 61.8% ratio. Other ratios include the 50% ratio and 23.6% ratio. You can also use Fibonacci retracements in conjunction with other technical analysis tools. For example, you might consider using a breakout or trend following technique as a currency pair passed through a Fibonacci retracement target. You might also use overbought and oversold indicators when prices are stretching to reach Fibonacci retracement targets. Generally, when an exchange rate reaches a Fibonacci retracement level, it will pause as traders take stock of the recent retracement to determine if the move was a pause that will refresh or a reversal point. Fibonacci retracements are calculated for you by the MT4 software offered by Rakuten Securities Australia.