Fibonacci Sequence Trading

Many traders in the retail end of the market are more interested in quick Forex profits on intraday trades and not many are as patient as the more professional traders. The institutional traders tend to place trades that last for many days or even weeks. This is because they tend to trade for the long term and in so doing, eliminate all the immediate market noise found in the markets.

The strategy to be discussed here is based on the Fibonacci sequence of numbers and the golden ratio, and is thus one of the Fibonacci Sequence Trading strategies.

Here are the Fibonacci sequence of numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, etc. As can be seen, each new number is derived from the sum of the previous two numbers and so this number sequence continues ad infinitum. We can also see that each new number is approximately 1.618 times higher than the number that precedes it. This number sequence is the basis of the ratios that Leonardo Fibonacci used in deriving his Fibonacci number sequence as well as the golden ratio of 61.8%.

The golden ratio is obtained by dividing one number in the sequence by the number that comes after it. Thus 55/89 = 0.61799 or 0.618 by approximation. Similarly, 34/55 is 0.6181. The higher the number sequence, the more accurate the golden ratio is.

Other ratios can be derived as follows:

• 6% ratio: divide one number by another number in the series that is found three steps higher. So 34/144 is 0.2361 or 0.236 by approximation.
• 2% ratio: divide one number by another number in the series found two steps higher. So 34/89 = 0.38202 or 0.382 by approximation.

The Fibonacci’s sequence of numbers is usually expressed as ratios between the numbers in the series. As far as technical analysis is concerned, the Fibonacci retracement levels tool (one of the tools used in this strategy) is formed when two extreme points (usually a major peak and trough) on a chart are taken and divided by the vertical distance of the most important Fibonacci ratios (23.6%, 38.2%, 50%, 61.8% and 100%). The tool then identifies these levels on a chart by drawing horizontal lines on them, thus identifying possible areas of support and resistance.

Indicators Used
The strategy is based on the Fibonacci retracement and Fibo extension indicators, which show the entry and exit points for the trade respectively. Trade entry confirmation is provided by the Stochastics oscillator (set to 10,3,3), which shows areas where the market is overbought or oversold with reference to the retracement points on the Fibonacci retracement tool.

How the Fibonacci Indicators Work

It is not enough to simply state how the strategy is played. It is important to understand how each indicator used in the strategy works.

1. Fibonacci Retracement Tool

Markets go through periods of strong trends and retracement. Pull any chart and look: there is never a straight line whether the market is going up or coming down. These retracements are caused by profit taking from those who entered the market early in a strong trend, and from bargain hunters who take advantage of these retracements to snap quick contrarian trades. One thing is sure: retracements ALWAYS occur in the markets.

The issue is that retracements do not last forever. At some point, those who took profits as well as new traders looking for cheaper prices to enter, will re-enter the market in the original direction. This stops the retracement and pushes prices further in the original path. However, it is difficult to know where retracement stops and where the market resumes its initial trend. This is what the Fibonacci retracement tool does.

1. Stochastics Oscillator

The Fibo retracement tool shows several areas where price action can retrace to. Usually there are up to 7 but usually 5 retracement areas by default: 23.6%, 38.2% 50%, 61.8% and 100%. So how does a trader know which one the price will retrace to? The Stochastics indicator gives us a guide. By showing overbought signals on an upside retracement, or oversold signals in a downside retracement to a Fibo level, the trader can detect where the retracement will stop and where price resumes its original action. This also helps the trader know where to set a stop loss for the trade.

1. Fibonacci Extension

The Fibo extension tool is used to find out areas where the renewed move of the currency pair will come to an end. This prevents a situation where a trader’s open trade is left at the mercy of reversing prices. The Fibo extension tool shows three areas where the price trend will possible end. These are at the 61.8%, 100% and 161.8% levels.

How to Setup the Strategy

The DAILY chart is the time frame of choice. The Fibonacci retracement indicator is traced on the chart as follows:

• If the trend is up, the tool is drawn from the lowest price on the left of the chart to the highest price on the right of the chart. If the trend is down, trace the indicator from the highest price to the lowest price. This action draws the Fibonacci retracement levels as horizontal lines on the chart. Price must have commenced retracement before you trace the tool so you are sure of the highest point of the chart.

Next, add the Stochastics oscillator. Oversold values correspond to <20. Overbought values are >80. Wait for retracement to occur. Then set the trades as follows:

BUY

Where the price stops its retracement at a Fibonacci retracement level where the Stochastics oscillator is oversold, enter a buy trade at the open of the new candle

SELL

Where the price stops retracement at a Fibonacci retracement level with the Stochastics oscillator at overbought areas, enter a SELL trade at the open of the new candle. In other words, the order is set the next day after the setup is complete.

Take Profit Settings

As earlier explained, what is used to determine the Take Profit is the Fibonacci extension tool. The indicator is plotted along the lines that the Fibonacci retracement tool is plotted, but a third point is added to the trace and this is at the exact retracement level where the entry parameters are reached. This tool should be traced only after the trade has been executed.

Trade Example

Here is an example of how this strategy is setup.

Stage 1: Apply the Fibonacci retracement tool and Stochs indicator to the daily chart and wait for entry parameters to be fulfilled.

Stage 2: Once the trade is on, attach the Fibonacci extension tool. On this chart, it displays the 61.8% 1^st target Fibo extension and the 100% (2nd target) Fibo extension.

Notice how the price of gold followed the trade expectations. This is a demonstration of how to use this strategy. Remember that no strategy’s past results, no matter how good they are, can guarantee future returns. So practice this strategy on a demo account until you can optimize its usage.