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What the Fibonacci is and how to use it

When using technical analysis people often fall into the ‘holy grail’ trap. There must be a set of technical indicators that work all the time. Trust me there are not. There is however one tool I have used over the years in my analysis, signals and software and this is Fibonacci.

The Fibs don’t lie

I’m not going to go into how long Fibonacci has been around for, or the sequence of numbers themselves. The rules of Fibonacci are all you need to know. They are all around us. For example, Fibonacci principles are the reason your forearm is the same size as your foot (try it).
I mainly use Fibonacci retracements. This is key to my trading, as I am using what I absolutely know to help me potentially predict the future. In my experience people understand the principle but all too often don’t see how they can use it in their trading. This is 100% of the time down to not knowing how to actually plot the Fibonacci lines.
To use Fibonacci correctly you need to identify one of the two main types of market movement:

1. Strong directional move (longer term)
2. An over-extended trading candle (shorter term)

If you do not identify one of these two PAST events you have no chance of using the Fibonacci principle and retracements to predict the FUTURE.
My basic rules of trading with Fibonacci are:

1. Identify the move you want to trade from
2. Use the 50% Fib as trade confirmation
3. Hold the trade to the retracement lines, but also in accordance with your risk and trading plan

Strong directional move

This is based on the H1 timeframe. I would say for longer-term Fibonacci directional moves you are looking for a minimum of seven candles in the formation through which to plot your lowest low to your highest high.
This is the GBP/JPY (12 candles):

In this strong up-trend we know that for 12 candles the GBP has strengthened against the JPY. We know the past upward move and now want to know one of two things: will the market continue the up-trend or will it retrace it?
Our scenarios are:

1. If we do not test or retrace back to the 50% Fib the up-trend is still valid. This means the market should move higher in the short term and make a new high above 189.569.
2. If we do not make a new high above 189.569 then the market has to test lower. If we test the 50% Fib and break it, then hold below, we should then make more lows below 187.937.

There is a little crossover, but essentially you have two target points and one pivot point on which to base your own trade call. After all, this is trading: you have to make your own decisions.
The element of time is critical here. You are trading this market off the hourly chart so you have to decide if you are willing to let several H1 candles close to make a longer-term position trade or if you will try to make a short-term scalp in the direction you feel the Fibonacci principles best indicate.
You can always use other supporting indicators to back up your theory. Take RSI:

In this instance we have tested the upper RSI over-bought limit (70) and are now looking to move back to over-sold (30). This may mean that a retracement and move back to the 50% and ultimately the 187.937 levels is the best trade.
I will go over the shorter-term over-extended candle Fibonacci trade in a future post. Look out for it.
Steve Ruffley
Chief Market Strategist