By Ed Ponsi, a globally recognized lecturer and teacher and the former chief trading instructor for Forex Capital Markets*

In a previous article (Fibonacci: Debunking the Debunkers - June 1, 2007), I discussed the results of a recent academic study of Fibonacci retracements and their use in various trading markets. Today, I'd like to present some tips on the effective use of this trading tool in the Forex market.

First, you might remember that we took a look at the AUD / JPY (Australian Dollar/Japanese Yen). We saw a nice bounce off the 38.2% level, coinciding with a reversal candle. The pair traded at an exchange rate of approximately 90.60, meaning that one Australian Dollar was worth approximately 90.6 Japanese Yen at the time.

Next, we checked in on GBP/USD (Great Britain Pound/U.S. Dollar). We noted repeated support at the 50% retracement level.

A week later, after Fib support held successfully, we saw the exchange rate had soared by 500 PIPs! At $10 per pip (per contract, or "lot" in Forex parlance), traders who caught even a small slice of this move were handsomely rewarded. Not bad for a one-week move!

Who Was Fibonacci?

First, for the uninitiated, we'll start with a brief summary. Leonardo Pisano Fibonacci was a mathematician who traveled widely with his father, an Italian diplomat. His book, Liber abaci, was published in 1202, after his return to Italy, and introduced the numeric sequence that came to be known by his name.

Fibonacci includes a series of ratios that are found throughout all of nature. These ratios appear just about everywhere -- in music, in Greek architecture, in the alignment of planets, in the way a tree sprouts its leaves, in the way a mollusk grows its shell. There are simply countless examples of this phenomenon.

What on earth does any of this have to do with trading? If you are a natural-born skeptic like me, you're probably not terribly impressed by anything you've heard so far, and rightly so. There is no logical reason to believe that any trading vehicle (stock, commodity or currency) will suddenly stop and change direction of its own volition when the price or exchange rate retraces by a particular ratio.

So, why does Fibonacci work in the Forex market? Because Fibonacci ratios are a deeply ingrained part of the Forex culture. Big banks, hedge funds and individual traders alike all pay close attention to these ratios and frequently place their orders at Fibonacci retracement levels.

If enough orders accumulate at a particular level, the combined power of these orders can actually change the direction of the exchange rate when that level is achieved. This is the essence of the self-fulfilling prophecy that we discussed in a previous article.

If my assumption is correct -- that Fibonacci works in the Forex market not because of magic but due to a self-fulfilling prophecy -- we can extrapolate certain conclusions from this premise.

Fibonacci Is More Effective on Longer-Term Charts

If we truly believe that Fibonacci is a self-fulfilling prophecy, we should live by the credo, "the more, the merrier." In other words, the more orders placed at a particular level, the more likely it becomes that the level will hold as support or resistance.

What can improve the chances that there will be a large quantity of orders at a particular Fib level? Visibility is the key. If the other players can't see the Fib level, they can't place their orders accordingly.

For example, if a Fibonacci level forms on a five-minute chart during the Asian trading session, any opportunity to place a trade based on this retracement is likely to come and go before European and American traders have wiped the sleep from their eyes. Because many of these traders will never observe this opportunity, there will be fewer orders placed at that level. This makes it less likely that the level will hold when the price reaches that area.

However, if the same scenario occurs on the daily chart, traders all around the world will have the time and the opportunity to place their orders accordingly. Because Forex is truly an international market, with traders located in every part of the globe, this aspect of Fibonacci trading takes on added significance.

Fibonacci Is More Effective on Commonly Used Retracement Levels

The most commonly used Fibonacci ratios are 38.2%, 50% and 61.8%. However, 23.6%, 78.6% and 100% are also legitimate Fib levels. Some traders even use Fibonacci "extensions" that go beyond 100%, such as a 161.8% retracement. There are also Fibonacci Arcs, Fibonacci Fans and Fibonacci Time Zones.

Which of these techniques will be the most effective? If we truly believe that a sizable quantity of orders (or a quantity of sizable orders) will make the difference, we must give more weight to the levels that garner the most attention -- the 38.2%, 50% and 61.8% levels. In Fibonacci, as in many aspects of trading, sometimes it's better to keep things simple.

* Reprinted (and modified) with permission from Online Trading Academy www.onlinetradingacademy.com