Fibonacci Ratios Explained – What are the “Fibs”?

“Fibonacci Ratios” are more an application than an indicator. This popular tool has its roots in the thirteenth century when the mathematician, Leonardo Fibonacci, identified many of the key numbers in his observations. Ralph Nelson Elliott and W. D. Gann used these ratios in their various analyses as evidence that market forces behave similarly to physical forces in Nature. These common ratios can be found in a strand of DNA and in the formation of galaxies in the Universe. Traders use these ratios to predict with uncanny accuracy future levels of support and resistance in the forex markets.

Fibonacci Ratios, or the “Fibs”, can be used in a variety of ways. Metatrader offers many options from lines, to fans and channels, but the most popular use is to determine what are called lines of retracement, those levels where a wave ebbs and flows to form support and resistance. After designating the beginning and ending points of a previous trend, the tool creates a series of lines where future expectations are highest, and traders then plan their trading strategies accordingly.

Fibonacci Ratios Formula

The Fibonacci application is common on Metatrader4 trading software, and the calculation formula sequence involves these straightforward steps:

  1. Activate the “tool” and drag to a beginning and then ending point of a previous trend (use high and low points of candlestick wicks);
  2. A series of lines, the “Fibs”, will be overlaid on the pricing chart

Software programs perform the necessary computational work and produce a Fibonacci overlay as displayed on the pricing portion of the following chart:

Metatrader 4

The Fibonacci Ratios overlay is comprised of the series of “Red” lines that appear on the chart. The “Red” dotted line connects the two “pivot points”. The common ratios are presented, which are 23.6%, 38.2%, 50.0%, 61.8%, and 100.0%. Targets can also be assigned above 100.0% by adding the various ratios to that figure. The reason why these ratios occur is unclear, but enough traders and automated “robots” fixate on these levels and gauge their trades by them that their eventual placement remains consistent. Awareness of these expectations can make you a more effective trader.

Traders use Fibonacci Ratios to plan out step-wise trading strategies that can be enhanced with pattern recognition and the use of a momentum oscillator.

The next article in this series on the Fibonacci application will discuss how this tool is used in forex trading and how to read the various graphical signals that are generated.

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Next Article >> An example trading strategy using Fibonacci Ratios >>

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