The price movement of any financial market is in wave format. Suppose a currency pair is on an up-trend, going from 1.0000 to 1.1000. After reaches certain top “boundary”, 1.1000 for instance, it will retrace – meaning pull back down – before resuming its initial up-trend. Fibonacci Retracements are levels at which the market is expected to retrace to after a strong trend.
Based on mathematical numbers that repeat themselves in all walks of life, Fibonacci retracements attempt to measure the likely points that a currency pair will retrace, or pull back to within a range. The key numbers in forex trading are 38.2%, 50%, and 61.8%. We can use the Fibonacci retracement numbers to gauge how far retracement will occur after the top “boundary” is reached.
Mathematically, it works like this:
- The 38.2% line. Calculate 38.2% of the size of the range. The size of the range is the boundary (1.1000) minus the lower boundary (1.0000). In this case, the size of the range is 1,000 pips. 0.382 * 1,000 = 382. It is expected that the asset will retrace 382 points from its current trend. Assuming the asset is going up from 1.0000 to 1.1000, it would retrace 382 pips from 1.1000. 1.1000 – 382 pips = 1.0618. Accordingly, this is a key level to look out for; you may want to buy here, as it is expected the upward trend will resume after reaching this retracement level.
- The 50.0% line. Same deal; 50% of the range (1.1000) is 500. Take that off from top (1.1000) since it is an upward trend. 1.1000 – 500 pips = 1.0500. Look to resume the upward trend here.
- The 61.8% line. 61.8% of the range is 618. 1.1000 – 618 pips = 1.0382. If the asset retraces to here, it is viewed as an opportunity to buy.
If the asset were on a down trend – meaning it had gone from 1.1000 to 1.0000 – then you would use the Fibonacci numbers to calculate the retracement regarding how far it went up before resuming the downtrend again. In this case, 31.8% would be 1.0000 (the end point of the current trend) + 318 pips (size of range – 1,000 – * 0.318).
Steps to draw Fibonacci Retracements
- Find an ongoing trend. Identify the top and the bottom of the trend. This can be a highly subjective matter. Traders can find the tops and the bottoms by looking at the charts and use their own judgment.
- Use a charting software which has Fibonacci function, connect the bottom to the top
- The default Fibonacci levels are 38.2%, 50% and 62.8%. The charting software usually allows users to change the default levels to draw their customized levels