Forex traders use Fibonacci ratios to determine future levels of support and resistance based on previous moves in the currency markets. In other words, previous moves in the market determine where the Fibonacci levels will be placed.
Fibonacci analysis is an exercise in identifying the support and resistance during both the trend retracement and the trend continuations based on a series of numbers and ratios derived from the Fibonacci sequence. This sequence was learned by an Italian mathematician Leonardo Pisano Fibonacci.
The sequence starts with the three numbers 0, 1 and 1. After that, the next number in the sequence is obtained by adding the previous two numbers. For example, by taking the first two numbers 0 &1; the next number obtained is 0+1=1 and by taking the next two recent numbers, 1 & 1; the next number obtained will be 1+1=2. So the Fibonacci sequence develops like this: 0,1,1,2,3,5,8,13,21,34,55.
The fascinating thing about this sequence is that the ratio of numbers at specified intervals is consistently the same, no matter how high you go. Fibonacci sequence gives us two very vital ratios. These two ratios appear over and over again in nature such as shells, pine cones, sunflowers etc. These two ratios also appear in currency markets.
The first ratio is 38.2%. It is calculated by dividing any number in the Fibonacci sequence by the number two places higher in the sequence. For example, in the above Fibonacci sequence, divide 21 by 55 (55 is two places higher than 21) you get 21/55=38.2%.
The second vital ratio is 61.8%. It is obtained by dividing any number in the Fibonacci sequence by the next number in the sequence. For example, divide 34 by 55 (55 is the next number after 34), you get 34/54=61.8%.
Trends in forex markets dont go in the straight line. Uptrends never go straight up and downtrends never go straight down. The price will always trace along the way as buyers and sellers enter and exit the markets. The vital question in every forex traders mind is how far these retracements will penetrate into the previous movement. This is where the Fibonacci ratios become useful.
Most forex traders use the three additional ratios of 0%, 50% and 100% in conjunction with the two primary Fibonacci ratios to round out the retracement analysis tools. Two secondary Fibonacci ratios, 161.8% and 261.8% are also used in the trend continuation projections. The ratio 161.8% is obtained by dividing any number in the sequence by the number preceding it. For example, in the above sequence dividing 55 by 34 gives 55/34=161.8%. Similarly the ratio 261.8% is obtained by dividing any number in the sequence by the two preceding it. For example, divide 55 by 21, you will get 55/21=261.8%.
Fibonacci ratios are used by currency traders and investors in making entry and exit decisions for each trade. The first ratio 38.2% is used as an entry point in a trending market. The ratio 0% is used as the exit point. The question that you may question is what the reason markets react to these levels is. You should not forget currency markets are just investors and speculators buying and selling currencies. So if many investors and speculators start believing in a thing, it starts becoming a self fulfilling prophecy. As most of the investors use Fibonacci analysis in determining the support and resistance and placing there entry and exit orders based on these ratios, the markets starts reacting to these levels.