Knowing where to enter the market and where to get out and why is as close to the Holy Grail in trading that you will ever get. Fibonacci numbers are obtained by adding the last two numbers in the sequence starting from 0, 1. Fibonacci sequence looks like 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377 and so on.
Ratios obtained by dividing a number in the Fibonacci sequence with the number before it and with two numbers before it are always the same. These two numbers 1.27, 0.618 and 0.382 are very important and occur frequently in nature. These three ratios are used to construct Fibonacci Retracements and Extension Levels.
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In an uptrend the market is making higher highs and higher lows while in a downtrend the market makes a lower lows and lower highs. So in an uptrend the price action makes a wave starting from a support level A goes up to the resistance level B then retraces back to a new support C that is higher than last support A. From this new support C it again reaches a higher resistance D as compared to last resistance B. So the movement of price action is AB, BC and CD.
Now after reaching the first resistance level B the price action retraces back down into the AB boundary where the bulls and the bears fight for the control. Fibonacci retracement levels act as the future hidden levels of support if the uptrend stays in place. The market is most likely to bounce back from one of this Fibonacci Retracement level 0.382, 0.5 or 0.618 and move up to the new resistance past the previous resistance level of B at one of the Fibonacci Extension levels 1.27 and 1.618.
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So while constructing Fibonacci Retracement and Extension levels we will start from point A and consider B as the end of the move. Considering the move AB as 100%, suppose AB is 100 pips. If the market bounces back at 0.382, we say the retracement was 38.2% or 38 pips. If it bounces back from 0.5 we say the retracement was 50% or 50 pips and if it retraces back from 0.618, we say the retracement was 61.8% or 61 pips.
After the market bounces back and takes a U turn at one of these retracement levels and rallies to the point D we say that the market has moved 27% above the original move AB or a total of 1.27%. Now if you want to become a serious trader no matter what market you trade, you should learn Fibonacci Retracement and Extension.
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