By Sean Hyman

Would you believe that in this high-tech, modern world, we still use an ancient profit secret that dates back to 1202 A.D. for our trading?

It’s true. In fact, savvy investors use this ancient concept in all financial markets each and every day. Hedge funds, banks, mutual fund managers and retail speculators all over the world use this secret.

I’m talking about Fibonacci levels.

So where does it come from? The first recorded evidence of it comes from Leonardo Fibonacci of Pisa. Leonardo recorded this concept in his book in 1202 AD.

The Fibonacci concept says there’s a number that is the sum of its two immediate predecessors. The pattern goes like this 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. You will notice that the pattern is you add the first two numbers together and you get the third number. This process repeats itself until infinity. However, the numbers develop a ratio of 1.618 roughly.

This ratio explains how rabbits multiply, the formation of tree rings, the distance between the planets, etc. There are many, many things in this world that are made up of Fibonacci ratios.

Therefore, many traders started using common Fibonacci numbers to figure out where a stock, commodities etc. would retrace to within its trend before resuming its up or down trend. And of course, Forex traders like myself also use Fibonacci numbers to find retracement levels.

Knowing How the Big Interbanks Use This Secret Gives You the Inside Track

So whether you believe all of the ratios of nature or not, just the fact that this tool is so widely used in financial markets gives it credibility.

You see, the big institutions use Fibonacci levels (or “fib levels” in Forex-speak) to pull the trigger on really large trades. And the big institutions rule over the Forex market. While no one institution can move a market as large as the Forex market, the major institutional money does create the major liquidity in the market, and enough institutional money in one direction can tip the scales for certain currency pairs in the market.

So wouldn’t it be helpful for you to know the concept they use so you can also use it in your trades? Of course…and that’s why it’s so wildly popular to this day.

The main thing Forex traders use these fib levels for are to see where currency pairs may retrace to before resuming its uptrend or downtrend. So it’s a tool used in trends to find high probability entry points into trends. In other words, the Fibonacci level tells you when it’s the best time to buy or short a particular currency pair.

While there are obviously many Fibonacci retracement levels out there, the ones that are focused on the most are 38.2%, 50% and 61.8%.

Let me show you what this looks like in real life trading to make it simple.

You can choose the drawing tool from most any charting package out there and look for the trend to draw upon. In an uptrend, you simply find the most obvious major low point and draw up to the highest point. (You always draw in the direction of the trend and not against it). From that, the drawing tool in the charting packages will produce the fib lines for you automatically. You can see these lines on the chart below.

The Price Bounces at the 50% Fib Level!

In a downtrend, we also draw our fib lines in the direction of the trend too. So we start drawing from the most obvious high point and draw all the way down to the lowest point. Then any charting package will automatically draw the fib lines on the chart for you so you don’t have to do any calculations.

In a downtrend, the 38% retracement of the downtrend held and bounced back downward to resume the downtrend. See the chart below.

In the Downtrend, the 38.2% Fib Is the Ideal Shorting Point

Common Myth Busted: You have to Time the Entry Down to the Second…NOT SO!

Over the years, I’ve discovered a couple of facts as I used fib levels in my trading – especially when the fib levels “hold” (in other words, “work to tell me when to get in and out of a trade”).

First, to use this trick: You have to be looking at a candlestick chart like the ones above. You’ll notice that when fib levels hold, the candle “wicks” at the fib level (in other words, the candle stretches up to hit the Fibonacci level). You’ll also notice that at least two or three candles hold that level before reversing back into the direction of the trend. Therefore, this gives you plenty of time to get into the trade.

(Remember: Depending on the chart’s timeframe, a single candle could be worth anywhere from 60 minutes or 24 hours of trading time. For more on candlestick charts, see my Five Minute Guide to Reading and Understanding Currency Charts.)

The above charts happen to be four-hour charts. So that means that each candle lasts for four hours. Therefore, in this case, you would have had about 12 hours to get into the trade near the fib level that holds. I point this out because many people think that they have to enter the trade at the exact second that the wick comes close to the fib level. NO! You have time to get into these trades.

You can use fib retracement levels on most any timeframe. However, the big banks are the ones that commonly monitor the larger time frames such as the daily and four-hour timeframe charts. Therefore, many believe that this makes fib retracement levels more accurate at these higher levels.

However, I also have trading buddies that use fib level retracements on five-minute and 15-minute charts and successfully use fib levels with those tight timeframes too.

But I will say this. You tend to get your larger bounces off of the larger timeframes, where the big banks are buying/selling. So that means that you may have the best “risk to reward ratios” in your trade if you start off in the larger timeframes with fib retracements.

One thing I like about this tool is that it keeps you focused on the trend and trading WITH the trend and not against it. It also gives you high probability entries, which can give you an edge in your trading over time. I also like the fact that it’s an indicator that deals directly with the price action and is plotted directly on it.

So when you spot a trend, don’t forget about this handy entry tool that can get you into a trend even if you’ve missed the first part of it…it gives you a good hopping on point for the remainder of the trend.