Fibonacci retracement, as it is used in technical analysis, refers to areas of support and areas of resistance based on the potential retracement of a currency price after a significant move either up or down. Fibonacci retracement levels are horizontal lines placed at key levels between the movements of prices. A trend line is then drawn between the high and low price point and Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100% are then computed and drawn to provide the Fibonacci levels. They were originally designed to cover the entire field of mathematics. However, they have been used in trading commodities for several centuries and have become a favorite tool for marking the movement of pullbacks in the Forex market.
As Fibonacci levels have become more popular, huge psychological triggers have been noted at these levels making the support and resistance levels tougher to cross. This allowing many traders to assume, that if a price does not retrace past the 38.2% level, the current trend will continue in the direction of the retracement. Should a price break the 61.8% level, then many trading systems indicate that the trend has been broken and the price will continue in the new direction to at least the 100% mark. The emotional triggers attached to Fibonacci levels can be seen as these numbers are tested continuously before a breakthrough or continuation occurs.
Fibonacci levels are extremely effective in a trending market. A popular method of trading based on purely these levels suggests that as the market trends up and Fibonacci levels are drawn on pullback, that when the price touches one of these levels of support, this is a buying signal that profit can be derived from. It is often best to note these levels when prices have consolidated at or tested a particular Fibonacci level over several different time periods. Observing the chart for just these sorts of moves can lead to profits not noted in other forms of technical analysis.
Often prices do not react immediately upon touching an individual Fibonacci level. The price may move beyond the level, return to it, move away again and then finally decide to make a move. They should be combined with trend lines in order to note the strongest points of support and resistance. Without confirming indicators, they provide only a guess as to the best point to enter a trade.
In conclusion, Fibonacci numbers, much like any other technical indicator, should not be used as an isolated investment tool. Fibonacci levels should be combined with other technical indicators that will provide a complete picture of the currency pair you are trading. Fibonacci numbers while based on pure mathematics are seen as more of an emotional tool than an actual technical indicator. Fibonacci levels appear to be extremely accurate, however many technical traders believe them to be a self-fulfilling prophecy thus putting more emotional pressure on their use than is necessary. However, Forex markets are an extremely emotional and psychologically driven financial field that requires an understanding of technical and fundamental reasons for price movement.