Take a stroll through a sunflower field and incredibly enough, you will realize something. Count the spirals from the centre of the flower head outward, and you will see specific patterns, to be exact - 21, 34, 55, 89, etc. These are not random numbers - they are part of the Fibonacci series.

The Fibonacci series is a famous sequence of numbers, where the value of each number (aside from the first two) is equal to the two preceding numbers in the sequence. This mathematical formula shapes so much of the world we see, from the number of chambers in a nautilus shell, to the number of branches on trees.

An interesting thought is that the Fibonacci series is used, still, to identify where price movement "should not" surpass in modern financial markets. Traders from around the world, apply these Fibonacci ratios to outline where currency values may pause, reverse or find support within the pullback. But, why does this concept, that was discovered centuries ago from an Italian mathematician and theorist, work well within today's forex market environments?

What is Fibonacci Retracement

Fibonacci retracement utilizes certain mathematical ratios to find potential support and resistance levels while price is pulling back from its previous price movement. The most popular ratios are 23.6%, 38.2%, 50%, 61.8% and 78.6%. Each of these numbers represents how far a price could "retrace" or pull back against its previous move before moving back in its original direction.

For instance, if you have ever climbed to the third floor of a building and then had to walk back down to the second floor to grab something and then continue your journey to the third floor, this is essentially what retracement is in trading. Your short journey back to the second floor is a retracement for price.

How to Draw Fibonacci Retracement

It is important to understand how to properly draw Fibonacci retracement within accurate analysis. If you don't draw the retracement correctly, the whole analysis makes no sense. Below is the step by step concept used by professional traders.

First we need to determine a trend. There should be a clear price move in one direction (up or down). The trend should be very obvious to anyone looking at the chart; if you're squinting and trying to decide if there is a price trend, it's probably not clear enough to make a Fibonacci analyis.

Combined with Others

Fibonacci analysis is much stronger when combined with other technical analysis tools. You should view Fibonacci as part of the team, not as an individual performer. Here are the best combinations.

Moving averages provide a sense of trend context that Fibonacci analysis cannot provide on its own. If both the 20-period moving average and the 50-period moving average are sloping upwards, and price is above both averages, you have at least some confirmation that the uptrend is intact. Fibonacci retracements in this environment are more likely to hold.

Risk Management and Trading Tips

Regardless of how good your Fibonacci analysis has been, good risk management remains a very important foundation for a successful trading career. Here are ways in which you can employ sound risk principles when trading Fibonacci setups.

When trading Fibonacci retracements, stop loss placement is extremely important. You can use a simple guideline of placing your stops just beyond the next Fibonacci level. For example, if you entered long at the 61.8% retracement, then placing your stop just below the 78.6% level is reasonable. The longer stop loss limits how far price can move against you, but it also gives your trade room to breathe while clearly identifying a point to exit if your analysis has fundamentally failed.

Conclusion

Fibonacci retracement is a powerful tool that provides escapism beyond the math of ratios to the emotions of the market. When thousands and thousands of traders are staring at the same levels, the short-term view formed by their combined reaction and collective psyche of will create the very support and resistance being guessed at in the ratios.

Remember the Fibonacci retracement is not a guarantee of price behaviour but rather a tool for probability based context in identifying all the best zones of confluence where we are likely to be able to factor a price reaction. That's the way we separate guessing and uneducated hope from a potential educated trade. Success with Fibonacci is in partnering the analysis with good risk management and extra confirmations.

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