Magic Fibonacci levels
Dwain Ross
05 / May / 21
Visitors: 287
The golden ratio both in nature and the market
One of the most powerful and widely spread tools of technical analysis is Fibonacci levels. The person we should be thanking for it is an Italian mathematician Leonardo Fibonacci who discovered a numerical sequence, which can be illustrated by the following example. If you put two rabbits in the same closed space, how many rabbits will be there as a result of reproduction in a certain amount of time supposing there is one born monthly and after one month the newborns can also reproduce? The resulting infinite progression looks like this: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144… Every number has peculiar properties – it is followed by the number equating to the previous two combined. There are other noticeable regularities: firstly, starting from 5, any of them is 1.618 times the number before it; secondly, every number is 0.618 of the following one. The correlation between them must definitely mean something and can be used. Not to mention, 1.618 has since been considered the golden ratio.
Traders began using Fibonacci levels as soon as they noticed that price oscillations frequently mimic the same numerical sequence. It proved to be so precise that the Fibonacci indicator got included in the standard settings of one of the most commonly used platforms MetaTrader 4. The argument for it occurs everywhere in nature and there is no reason why we cannot apply it to market. Let's assume the market is moving up and then starts selling off. Traders would use Fibonacci retracements to try and figure out how far back this market is going to fall before it resumes its trend.
We have various calculations coming from the Fibonacci numbers. What people do is conduct divisions and convert them to percentages. On the scale of 1 to 100, Fibonacci ratios are 23.6, 38.2, 50.0, 61.8 and 76.4%. These ratios are considered to be key indicators (forecasting possible future price movements). The indicator visualizes these levels on the chart and provides you with a viewpoint of where the later movements could head. Traders might take a move of, for example, 100 points. When the market drops back 23.6% of that move, it constitutes the first Fibonacci retracement level. So they look if the market holds there. If the market breaks, the next level they look at is 38.2%. The assumption is that they are going to hit the levels of support in an uptrend or resistance in a downtrend. The thinking is that if the market drops back more than 61.8%, it is going to go back to where the move started.
How to draw Fibonacci lines
The indicator is included in MT4 as the standard one. The way you stretch these lines and how accurate they are on the graph are going to determine how profitable this method is going to be. In order to put the Fibonacci Retracement lines correctly, you need to: find the trend which has changed to the opposite; open the indicator; pull the net from the point where the trend exhausted and started changing direction to the point where it started. The result is supposed to look like this: a thin red dotted line marks the trend which we used as a base for the Fibonacci levels in MT4, horizontal yellow lines mark the support and resistance levels used as points of retracement (along with percentage figures).
If you want to operate it manually, choose the correction levels feature in the program or on the price chart. Start from the lowest point of the trend and pull towards the highest point. You are going to see 5 horizontal lines displaying the price movement levels or the trend length. These lines can work as levels of resistance and support depending on whether the currency pairs or stocks are traded above or below them. The bigger the timeframe you are using, the more precisely these set levels will work. Thus, traders simply need to find a falling trend, set the Fibonacci sequence correctly, wait for a confirmation and open the trade.
Many insist on stretching the net from left to right but as history has demonstrated, there is no particular difference. As soon as you learn to do it the right way, you should notice the results in any case. Some also stand behind the notion that the exhausted trend should have 5-wave structure. This method is supposed to eliminate false signals and the Fibonacci lines would work with more precision.
Practical application
The situation needs to meet two conditions: 1. there is a distinct trend; 2. there is a retracement movement. Here we need to draw the Fibonacci lines in order to determine where this retracement movement is going to end and where the overall trend is going to resume. You can use it at least twice: on the movement itself (which is more dangerous); on the outer positions of the resumed trend (which is safer).
As an example, we take a currency pair which experienced a long-lasting strong downward trend and now is in the process of retracement. This way, we can use the Fibonacci lines to predict the approximate level where the retracement will end (in this case, it is resistance). Since the trend is strong, we have the evidence to believe that the movement is going to be minimal – at 23.6%. We open the trade in the beginning of the move and set the stop-loss below zero line and take-profit somewhere slightly above 23.6%.
If you wish to test and adjust the strategy based on the Fibonacci retracement lines, you can easily do that according to your trading style. There are no rules set in stone making it one of the perks of this approach. A strategy worth exploring uses these guidelines: the net is put on a 4-hour graph with the global trend as the basis, which can form somewhere between a month and half a year. You use the hourly graph for usual trading; the Fibonacci sequence can be useful for up to 6 months. The typical order duration is 2-3 days but it some cases, it can be extended to a week. All trades are made in the direction of the current trend and opposite the one used to form the numeral sequence. The Fibonacci Retracement was also proved profitable for trading gold and silver. As for currency pairs, it has been working well for the GBP/USD pair. It is not the best strategy to use on currencies of countries tightly connected to oil, especially for the last couple of years.
You can use the Fibonacci levels for Forex scalping but remember that the smaller your graph time frames are, the more false signals you receive. So try to combine this strategy with complementary indicators for this style of trading. Stochastic oscillators with the standard setting of 9-3-3 and 21-9-9 or the typical 50-period moving average are quite useful. Obviously, you absolutely do not have to stick to these specific guidelines because everyone treats the market differently. Key element of success is finding the system which suits your perception.
Trading aggressively vs. conservatively
If you consider yourself an aggressive trader, then you need to open the trades at the level of 23.6%. This level is appealing for people who are impatient and long for the rush of moving forward, typical characteristic of aggressive style. The majority of truly aggressive traders experience a decent amount of failures on the GBP/USD currency pair. Although, most of the times, the counter-trend bounce at 23.6% is the attribute of this exact pair. If we examine counter-trend bounce of other currency pairs, we would see that the retracement movement usually continues to the level 38.2% not having any particular counteraction.
If you prefer a more stable style and you behave sensibly and conservatively on the market, then you should open at 38.2% with the profit take at 23.6%. Conservative traders usually stick to this method and it works for them perfectly well. There are moments when it continues past 23.6% after the counter-trend bounce so you can occasionally set bigger goals. However, do not be greedy as it can backfire. 23.6% or 38.2% rarely come all the way down to 50.0 % without any distinct and unambiguous retracements. But if they did reach this level and there is still no bounce, do not hesitate to open. In that case, your take-profit should be either at 23.6% or at the zero line (although, you put yourself under some risk). Do not sit in the market for too long; the longer you hold a position, the more risks you expose yourself to. All in all, set achievable goals.
Magic Grid strategy
This one is a trend trading strategy which is based on the Fibonacci levels and two moving averages. The strategy was tested, firstly, on a demo account and later on a live account. There was a decent result after this trial. Thanks to the strategy, there was a 56% profit after 7 months. The system is conservative and will be appealing to traders with this type of temper. It is fairly easy to use because traders do not need to constantly keep an eye on the graphs and intervene.
To make sure this strategy works at its fullest you are advised to trade EUR/USD pair on the time frames Н1-Н4. You will need several instruments of technical analysis. The first Fibonacci grid is for determining the trend and possible price retracement movement. The second Fibonacci grid displays Fibonacci extension on the basis of which you will determine the optimal moments for entering the market. If you use the MT4 terminal, there is a default Fibonacci grid in the instruments panel. Having added the grid on the graph, you need to open the Fibo settings where you can adjust the indicator and add new levels onto the grid. In this case, you will need to add the level of 76.4%, which will be the guideline for entering the market (specifically, if it is broken through). To add this level, open the tab 'Fibonacci levels' and, in this instance, put in the parameter 0.764.
Other than that, Magic Grid strategy uses moving averages. To add them onto the graph, open the instruments tab and choose ' Moving Average'. Following the guidelines of this strategy, you will need two MA indicators with different settings. The first MA will be slow with the period of 200; it is adjusted to a simpler method of MA and used for closing. The second MA will be fast with the period of 100; apart from that, their settings are identical. You will use the moving averages for establishing behavior of the current trend. The analysis is conducted as follows: if the fast MA2 is above the slow MA1 or crosses it in the upward direction, it means the trend is rising; if the fast MA2 is below the slow MA1 or crosses it in the downward direction, it means the trend is falling.
Trading guidelines
You start with determining the trend according to moving averages. Let's use a rising trend as an example here. Then you proceed to adding the first grid Fibo1. It stretched from the beginning of a trend do the maximum if the current trend. You need to confirm the retracement, which is signaled by the price moving past the 38.2% and its subsequent move toward the level of 76.4%. Then you add the second Fibonacci grid Fibo2 to measure the retracement. The grid is allotted between the trend maximum and the point where the retracement ends. The signal for opening the long position emerges when the price has passed the level 76.4% of the second Fibonacci grid and the bar is closed above this level. Take-profit corresponds to the first Fibonacci extension which amounts to 161.8% of the second grid. The stop-loss corresponds to the local correction minimum. Remember that this algorithm is for the rising trend.
This is the simplest way of opening the position for the given strategy. If you want to increase your earnings you might consider opening several positions simultaneously (although, not too many). In this case your take-profit will amount to 161.8% after the first trade, after the second one you take at the level of 261.8%, after the third one – 423.6%, etc. Moreover, the Fibonacci strategy is accompanied by trailing stops. In a scenario like this you close the first position according to the take-profit; the stop-loss of the other ones is in the black. After closing, the second stop-loss moves to the take-profit level of the first trade.
Additions to Magic Grid
If having drawn the first Fibonacci grid, the price continues further movement following the trend without correction (having reset the local minimum), and then the grid readjusts based on the new peak. You are supposed to do it until the price breaks through the level 38.2% moving towards 76.4%. Generally, correction forms exactly here. All the measurements and arrangements of the grid start all over again but in the opposite direction. The second grid is added after the correction happened in the range between 38.2% and 76.4%. As the correction forms new turning points and the price does not reach 76.4%, the grid is added relative to new minimums. After closing all the positions, the trading is reset. The algorithm is the following:
- You determine the trend using moving averages.
- The trend is measured on the first Fibonacci grid.
- Correction is formed and measured on the second Fibonacci grid.
- The price goes beyond level of 76.4%.
- You open the positions in the direction of the trend (if the trend is falling, you follow the same scheme but in opposite).
How to use the Fibonacci sequence for maximum profit
It is not particularly important how many successful or profitable trades you have made. How many times you have failed and how you managed your mistakes deserves far more attention. Ultimately, it is also arguably irrelevant whether you use the Fibonacci levels in MT4 or work with Ishimoku indicator. The main thing is not maximizing the profits but minimizing the losses. Be sure, you can definitely achieve that if you stick to some basic rules. Never use only one strategy, combine at least two simple systems; do not go overboard with your trading attempting to open orders as frequently as possibly – this a quantity over quality type of matter; try to work on the time frames no lower than 1H even if it seems boring or non-beneficial (the best systems provoke boredom rather than cheering. Warren Buffett would remind you to keep track of economic calendar and times when news come out during the trading day so that you will not fall prey to unexpected publications affecting the market. Keep track of your statistics – write your actions down in detail so that you have all the data to analyze where you succeed or fall short. Gather as much experience and knowledge as you can – every trading book is supposed to catch your attention.
Many traders and investors believe that not every single level out of the sequence show the same results on the price graph and figured out the following coherence:
- 23.6 – this level is considered weak, you need a clear confirmation in order to roll with it.
- 38.2 – this one is an important point; it is very likely that the price will bounce back at this level.
- 50.0 – it lays somewhere in between the previous two; there is a high probability that it will work as it should. Actually, this percentage has very little to do with the Fibonacci sequence but trader found that there is a tendency to reverse after retracting half of the previous move.
- 61.8 – it is a similarly strong level as 38.2.
- 80.9 is also a reliable one.
If you will work exclusively in the direction of a trend, filter out the false signals using simple complementary tools, not dismiss the strength of these levels nor fall on small time frames, your efforts will lead to desirable results and risks will be minimal. Obviously, remember basic rules of risk management and trading psychology. If your emotions are over the top, you might want to reconsider your attitude.
The trading strategies based on the Fibonacci sequence are not difficult at all, there are no unnecessary complications but still bring a decent amount of profit. Some prefer to combine it with other indicators. Almost anyone can manage this task of building a grid on the chart using the medieval mathematician's numeral levels and find out what levels of support and resistance will emerge. Try not to go for small time frames trading with this system and filter out false signals in combination with other indicators and follow the trend.
