Forex Fibonacci Retracement Trading Strategy

Our Approach to the Forex Fibonacci Retracement Phenomenon

Before we begin with the Fibonacci Trading tutorial, be sure to review our primer on identifying trends in the Forex market (and how they differ from less liquid stocks) at our Ultimate Trend Indicator for Forex... Your Eyes page.

You might've heard about the use of Fibonacci retracements as a prediction tool in Forex. Most of the gurus would introduce this strategy with all the theory and math behind the Fibonacci number series and how it applies to nature. We'll keep it as short as possible (and you can skip it if you don't care): Basically, it comes from the idea that every subsequent number in a series is the sum of the two numbers that came before it. Yes, it occurs all over the place in nature and even in the composition used in professional photography and the way a director frames a shot in a Hollywood film.

The real question is: Does it really occur in financial markets? The short answer is: probably not... at least not as a natural phenomenon, as in the way we see appealing facial structures and photos. What's much more likely is that this phenomenon has been identified long ago as a possible trading tool in financial markets, and as a large scale self-fulfilling prophecy, many of the real market movers (the smart money, the people whose trades are big enough to move the massive interbank Forex market) use it and therefore cause the phenomenon to prove fairly accurate for all practical purposes.

Here's the part that should matter to you: When a trend is exausted, and a turning point occurs (again, you should know how to see this with your eyes; read our introduction to trend trading to learn this basic skill if you haven't yet), then the Fibonacci tool is often an effective way to predict where the retracement is likely to end and the preceding trend might continue. (Notice that we emphasize might... nothing in trading is for sure, and it doesn't have to be. You only need to make more money than you lose, you never need to be perfect.)

Here's an example of a Fibonacci retracement setup:

In the picture above, you see a mostly clean trend making higher highs and lower lows... until that last big push into the upside, which looks like it exhausted the buyers. (Why? Look at the "wick" stickout out of that last white candle. That means despite that fact that it closed higher than it opened (the fact that it's a white candle), its high is well above the closing price. In other words, during the hour that this candle represents (in an hourly chart; the same principle can be scaled to any other time frame), buyers ate up enough of the sell/short orders in the market to push the price higher, but then failed to hold that level toward the end of the hour. Is this, alone, enough information to trade on? No. But it's a situation where you should be looking for a good entry point within the next few candle periods (hours, in this case.) Surely enough, the next hour (the last black candle on the right) broke the low of that last big push upward.

Now that we have a swing low and a swing high (peaks on both sides followed by a sign of reversal), we can go ahead and draw the Fibonacci tool on it. In MetaTrader, simply click the Fibonacci tool and drag it from the low to the high (or if this were a swing high followed by a swing low, you would drag it from the top to the bottom.) Other trading platforms offer the tool as well, but the method sometimes involves clicking rather than dragging with the tool.

There are two ways you can approach this situation:

1. You can try to scale into a position in the direction of the retracement that just began (eg. in this case, start building a short position using the unbroken high at B as your stop loss, so that any profit target that is larger than the distance between your averaged entry price and your stop loss would result in a positive reward-to-risk ratio.

2. Wait until the market has touched the 50% Fibonacci retracement level and start scaling in to a position against the retracement (in the direction of a possible continuation; in this example, this would be a long position.) Set your initial stop loss a few pips below the 100% Fibonacci retracement line (below the bottom of the entire range, which in the example, would be below the low established by A.) You can scale into this position at the 61.8% Fibonacci retracement line. Your average position should be closer to your stop loss than half way to the 0% line. Now, your initial target can be the 0% line itself (the high established by B) somewhere past it. Since this is a "continuation trade" (relative to the swings that we drew on with the Fibonacci tool; in the example, A to B), you can target a resistance level above point B if you expect a continuation past this range. In lower time frames like 5-minute or 15-minute charts, this can work especially well during market opening times like the London open (8am UK local time, which is GMT for most of the year, but BST in UK summer months) since the burst of volatility created by the banks opening their trade desks tend to drive trends better than other times of day. You can read more about this phenomenon at our London Forex Opening Range Breakout strategy page.

... Or both.(#1 followed by #2, since they can be two independent trades.)

The primary goal of this strategy is not to be 100% accurate. No trading strategy in Forex, or any financial market in the world, can guarantee that. The goal is to scale in to a position so that your average cost basis creates a reward-to-risk ratio in your favour (ie. Your losses will be smaller than your winning trades.) As long as the Forex market continues to make retracements toward these levels (before breaking the previous swing) more often than 49% of the time; and then bounces off of them (before breaking the full 100% Fibonacci retracement level) more often than 49% of the time, all you need is a reward-to-risk ratio of greater than 1:1 to come out on top. After that, it's a matter of exploiting your edge repeatedly to build up your capital.

Important Note: We made a few references to scaling in to positions, and building up an average cost basis. This does NOT mean that we encourange "averaging down" on losing trades. There's a big difference between a beginner who refuses to admit being wrong and adds to losing positions, and a professional trader who plans out the risk of a trade and starts off smaller than full size to gradually build up to the full intended position. (The difference is that it is planned, and that the full position, even after all the scaled-in averaging, is only the size of one planned trade, not twice or four times as in the case of a loser who refuses to admit being wrong.) This is a key difference between a strategically averaged position and the actions of a beginner who refuses to accept reality.