Developing a forex trading strategy requires a plan. You want to have an impetus that helps you get in and exit your position with consistent gains. The risk management techniques that you employ when you create your strategy will be pertinent in creating your success. To approach creating a risk management strategy, you might consider using critical support and resistance levels created by Fibonacci retracement levels. This technique will give you an objective way to stop out of your position or take profit.
What is Fibonacci?
Several technical analysis tools have been created using a mathematical formula that an Italian mathematician Leonardo of Pisa discovered. They were first described in Indian mathematics as early as 200 BC. Applications for using the Fibonacci numbers stem from trading to computer algorithms. They also appear naturally. The spirals of a sunflower are said to be in the form of Fibonacci numbers. Fibonacci numbers help create the golden ratio, which is the main quotient used when applying Fibonacci numbers to technical analysis.
What is Technical Analysis?
Technical analysis studies past price movements and is used to determine futures forex exchange rates. Technical analysis can be categorized as techniques used for support and resistance, pattern recognition and studies, and analytics.
Support and resistance are price levels that an exchange rate has difficulty breaching. This area is where Fibonacci levels are most impactful. Pattern recognition allows a trader to evaluate a pattern to see if an exchange rate is likely to continue to move in the direction of a trend or reverse course. Studies are usually mathematical methods that determine trends, momentum, and oscillation.
How Are Fibonacci Numbers Used?
Fibonacci numbers create a sequence of numbers calculated via a golden ratio. The number is the sum of the two preceding numbers. The mathematical formula is XN=XN1 + XN -2. The golden ratio that is created from these numbers is 0.382 and 0.618. These two golden ratio numbers are used in Fibonacci retracements to generate support and target resistance levels used in forex trading.
Here is an example of how Fibonacci retracements can be used in forex trading. Below is a chart of the EUR/USD, several moving averages, and a Fibonacci retracement study. The subjective piece of the puzzle determines the retracement you are interested in evaluating.
You might be looking for a downward move or an upward move in a currency pair exchange rate that is beginning to reverse.
In the EUR/USD chart, you can see a decline from June 2021 to March 2022. The move length between these periods is calculated, and a retracement level is calculated. Many ratios, such as the 23.6% and 50% and the 78.6% ratio, are added to the golden ratios of 38.2% and 61.8%.
How Can You Use Risk Management with Fibonacci Retracements?
In this example, a trader who believes that the EUR/USD will rise might consider placing a stop below the recent low near 1.08 to see the currency pair grow to the first golden ratio level of 38.2% near 1.1368. The risk-reward on this trade would provide you with a more significant gain than a loss, and it points explicitly out risk management levels that can be used to make your trade.
An additional risk management technique would be to use the 38.2% retracement level as a place to take some profits. If you took half of your earnings at 1.1368 and then let the rest of your volume move higher until it reached the 61.8% retracement, you then have a trailing stop trend following the process.
Here is an example. Say you purchase $1000 of EUR/USD at 1.10. If the price falls below 1.08, you will lose 1.8% or $18. If the price rises to 1.1368, you will make 3.3% of $33. Lastly, if you took half of your position off and let the rest of the position continue to run-up to the 61.8% retracement level, your profits would be $16.5 plus $27.3 or a total of $43.77 on the $1000 you invested in EUR/USD.
The Bottom Line
The upshot is that there are many ways that you can use technical analysis to trade the forex markets. You can use studies that track momentum and trend following. You might also use pattern recognition which helps you decide if the price will continue with the trend or reverse. You might also you support and resistance levels. One of the best techniques to use in conjunction with support and resistance is Fibonacci retracements. The golden ratio profits specific levels where you can stop loss and take profits. These numbers give you an objective area to either take your profits or let them run.
