As a discretionary trader, using Fibonacci retracement ratios is my favorite
technique for identifying profit targets. Many books discuss using
Fibonacci as a trade entry technique, but I prefer to use them to identify
profit targets. Fibonacci ratios provide a simple and consistent profit management
technique that regularly provides sound risk-to-reward ratios.
Fibonacci refers to a mathematical sequencing of numbers known as
a Fibonacci sequence. The formula was introduced to the European world
in 1202 in a book titled Liber Abaci, written by Leonardo of Pisa. Leonardo
went by the nickname Fibonacci. In his book Fibonacci used the rapid
population growth of rabbits to explain the principles of the Fibonacci sequence.
In the sequence the first two numbers are 0 and 1, and each subsequent
number is the sum of the previous two. The sequence is calculated
using recurrence relation, creating a sequence of numbers as follows:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 610, 987. . .
I am a trader and not a mathematician, so I won’t pretend to understand
the formulas and theories behind the Fibonacci sequence. If you are
truly interested, there are many good books written on the subject and how
it relates to the financial markets. What I do know is that the Fibonacci sequence
can be calculated as ratios and adapted to the financial markets.
There are many ratios a trader could choose from to identify a profit target,
but one in particular stands out among the crowd: 61.8 percent. This
ratio is important because it equals a mathematical constant that can be
found throughout nature and manmade environments that is known as the
golden ratio. This ratio represents an irrational mathematical constant that
can be found throughout geometry and calculates to 1.618 percent. The ratio
is found naturally in the arts, architecture, nature, music, geology, and
even the structure of the human body. Having read earlier chapters in this
book, you know I’m a believer in supply- and demand-based influences related
to price, but it is hard to deny the theory of Fibonacci’s golden ratio of
61.8 percent. I don’t believe in voodoo, but when it comes to pulling profit
targets out of thin air in a systemic, mathematically based way, I’ll take all
the help I can get.
Fibonacci ratios come in two flavors: retracement ratios and extension
ratios. Whether you use a retracement ratio or extension ratio to identify
a profit target depends on the style of trade you are planning. When the
market is ranging or you expect the market to move against the preceding
price action, you should use retracement ratios to identify a profit target.
When the market is trending, extension ratios allow you to project a profit
target into the future to capture the most profit from a trend trade. In this
section we review how to draw and use both retracement and extension
ratios.
Using Fibonacci Retracement Ratios
to Identify Profit Targets
Virtually any charting software will draw Fibonacci ratios for you. In this
case we are interested in drawing Fibonacci retracement ratios. Retracement
ratios are useful to identify profit targets when you believe the market
will reverse direction. This can happen when a trend is coming to an end
or when the market is stuck in a range. Fibonacci retracement ratios are
drawn by connecting two price points. Usually an extreme low, known as
a swing low, and an extreme high, known as a swing high, are connected
using the Fibonacci ratio tool offered by your charting software. Fibonacci
retracement ratios are automatically calculated between the swing high
and swing low prices, once they have been selected.
Figure 5.4 demonstrates a swing low and swing high price with
Fibonacci retracement ratios drawn. Fibonacci ratio tools will typically
draw three standard retracement ratios, which are 38.2 percent, 50 percent,
and 61.8 percent. You can change them or add other ratios if you
prefer. For the purposes of this book we are only interested in the 61.8 percent
retracement ratio for use as a profit target. Traders are traditionally
taught to draw Fibonacci retracement ratios by connecting a swing low
and a swing high, as shown in Figure 5.4. However, I’m not interested in
how everybody else uses Fibonacci.
When I draw Fibonacci retracement ratios, I connect a swing high or
low to the entry price of my trade. This technique allows me to identify a
profit target based on my entry point and not necessarily the swing high and
low. In many cases it also increases the distance between my entry point
and the 61.8 percent retracement ratio because I’ve shaved a few pips off
the top or bottom of the Fibonacci grid. Fibonacci purists will suffer a heart
attack over what I just said, but remember, I’m not trying to be academic. I
use Fibonacci simply to identify potential profit targets.
Figure 5.5 illustrates how a trader can use Fibonacci to establish a
profit target when selling the USD/CAD. Figure 5.5 is the same chart as
Figure 5.4, but the Fibonacci ratios have been adjusted to reflect the entry
point of a resistance-based trade versus the traditional price high.
One subtle but important advantage gained by using Fibonacci retracement
ratios as profit targets is grounded in supply-and-demand theory.
Since Fibonacci retracement ratios are created inside a swing high and
swing low, you know the market is able to potentially reach your profit
targets because it has traded at those price points in the recent past. You
are not asking the market to go outside a range it hasn’t already been able
to trade at for you to make a profit on the trade. Additionally, by using the
61.8 percent retracement ratio, you are not asking the market to retrace
the entire length of the range between the swing high and the swing low
price. From a supply and demand perspective, Fibonacci retracement ratios
make a lot of sense to use as profit targets.
Unfortunately Fibonacci retracement ratios are limited to predicting
profit targets within the range of a swing high and swing low price. When
the market is trending and making new highs or lows, retracement ratios
lose their effectiveness as tools to identify profit targets. In the next
section you will learn how to use Fibonacci extension ratios to identify
profit targets during a trending market.
Identifying Profit Targets with Fibonacci
Extension Ratios
When a trending market is expected to continue making a new high or
new low price, Fibonacci extension ratios are a powerful tool to identify
profit targets. Using extension ratios, traders are able to project where a
trending market may be headed and establish a profit target at a price at
which the market hasn’t traded yet. Fibonacci extension ratios are drawn
using the same tool as retracement ratios in most charting software.
Extension ratios project Fibonacci ratios beyond the high or low price
used to calculate retracement ratios. As you might expect, extension ratios
are correlated with retracement ratios that share the same percentages.
Common Fibonacci extension ratios include 138.2 percent, 150 percent,
and 161.8 percent, which correlate with their retracement counterparts,38.2 percent, 50 percent, and 61.8 percent. Although these ratios are the
most common, you may create custom ratios with most charting packages
if you desire. In this section you learn how to use Fibonacci extension
ratios to manage profit within the context of a trend.
Using Fibonacci Extension Ratios The advantage of Fibonacci extension
ratios is their correlation to retracement ratios. During a trend,
the market often retraces its steps after making a new high or new low.
This retracement often stops along well-known retracement ratios such as
38.2 percent or 61.8 percent, as shown in Figure 5.6. During the USD/JPY
downtrend, the market retraced its steps three times before making a
new low all three times. When a trade entry using any method in this
book happens to correspond with a Fibonacci retracement ratio, an opportunity
exists to use extension ratios as a profit target. To identify the
profit target, use the extension ratio that correlates with the retracement
ratio at which you have entered a trade. This idea is demonstrated in
Figure 5.7.
For example, assume that you have entered a trade along support after
the market has retraced to a 61.8 percent retracement ratio. Assuming that
the trend will continue higher, you can use the 161.8 percent extension
ratio to identify a profit target for this trade. If the trade had been entered
near the 32.8 percent or 50 percent retracement ratio, you should use the
132.8 percent and 150 percent extensions ratios for profit targets. Figure 5.7
demonstrates a GBP/JPY trend-based trade using Fibonacci extensions to
identify a profit target.
Finally, Fibonacci is an easy tool to use and provides a systematic,
repeatable process for identifying a potential profit target for each trade
you plan. When a trader combines Fibonacci ratios with a risk-to-reward
ratio of at least 1:3, he has a mechanical process with built-in positive
expectancy. This profit management technique should produce a winnin gresult, provided that the trader’s winning percentage is greater than
30 percent.
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