Investors use Fibonacci ratios to project future levels of support and resistance based on previous price moves in the forex markets. In other words, previous price moves in the currency market determine where the Fibonacci levels will be placed.
Fibonacci analysis is an exercise in identifying and determining the support and resistance during both the trend retracement and the trend continuations. It is based on a series of numbers and ratios derived from the Fibonacci sequence. This remarkable sequence was discovered by an Italian mathematician Leonardo Pisano.
The sequence begins with 0, 1 and 1. The next number in the sequence is obtained by adding the previous two numbers. For example, take the first two numbers 0 &1; the next number will be 0+1=1. Take the next two recent numbers, 1 & 1; the next number will be 1+1=2. So the Fibonacci sequence looks like this: 0,1,1,2,3,5,8,13,21,34,55.
The remarkable thing about this sequence is that the ratio of number at specific intervals would consistently be the same, no matter how high you count the numbers. Fibonacci sequence gives us two very important ratios. These two ratios appear over and over again in nature such as sunflowers, shells, pine cones etc. These two ratios also appear in forex markets.
The first ratio, 38.2%, is calculated by dividing any number in the Fibonacci sequence by the number two places higher in the sequence. For example, in the above Fibonacci sequence, divide 21 by 55 (two places higher) you get 21/55=38.2%.
The second important ratio is 61.8%. It is obtained by dividing any number in the Fibonacci sequence by the next number in the sequence. For example, divide 34 by 55 (55 is the next number after 34), you get 34/54=61.8%.
Trends in forex markets dont go in the straight line. Uptrends never go straight up and downtrends never go straight down. The price will always trace along the way as buyers and sellers enter and exit the markets. The important question in every forex traders mind is how far these retracements will penetrate into the previous movement. This is where the Fibonacci ratios become useful.
Traders use the three additional ratios of 0%, 50% and 100% in addition to the two primary Fibonacci ratios. Two secondary Fibonacci ratios namely 161.8% and 261.8% are also used in the trend continuation projections. The secondary ratio 161.8% is obtained by dividing any number in the sequence by the number preceding it, in the sequence dividing 55 by 34 gives 55/34=161.8%. Similarly the ratio 261.8% is obtained by dividing any number in the sequence by the two numbers preceding it, divide 55 by 21, you will get 55/21=261.8%.
These ratios are used by forex traders in making entry and exit decisions. The ratio 38.2% is used as an entry point in a trending market and the ratio 0% as the exit point. The important question is why markets react to these levels. Dont forget, markets are just people buying and selling. So if many people start believing in a thing, it becomes a self fulfilling prophecy. Since most of the traders use Fibonacci ratios in setting their entry and exit targets, the markets starts reacting to these levels.
Related posts:
