Why Fibonacci Levels Work So Well In The Forex Market?

In the currency market, the Fibonacci levels are keenly observed. You might hear a lot about the Fibonacci Sequence being a very important sequence having important applications in nature. Fibonacci numbers are found in flowers as well as in the orbital rotations of the stars. You might also hear that Fibonacci numbers describe the perfect human body. This is all absolute nonsense. Fibonacci numbers are dubious scientifically. However when it comes to forex trading, Fibonacci numbers are critical.

So, why do the Fibonacci Levels works so well in the forex market? The numbers that are keenly observed by forex traders are the 38.2%, 50% and the 61.8% as well as Fibonacci Extension ratios that are 138.2% and 161.8%. The typical method used in technical analysis is to draw a trend line from the swing low to the swing high in an uptrend or swing high to the swing low in a downtrend and then attach these Fib Lines at the 38.2%, 50% and 61.8% of the swing and consider them as natural support and resistance.

Now, why use these Fib Levels when they are of dubious merit. The most obvious explanation that comes to the mind is that since most of the institutional investors and traders are using these levels, it become a self fulfilling prophecy. Since these Fib Levels are being observed keenly by the market participants and everyone is referring to them in their analysis, they become an important reference tool.

But, there is something more to it. If you look at these numbers, they are infact simply representing one third and two third of any move in the market. There is a deeper explanation why these levels work. It relates to the market dynamics. Dealers are supposed to take the opposite side of the trade as market makers. When clients want to buy the currency in an uptrend, dealers are supposed to sell in order to provide liquidity to the market.

Now dealers have to deal with a large number of clients. So, in order to offset their positions in the market, they never enter the market at one point, rather they continuously scale in and out of the market with the price action. They use parabolic scaling. So, what they do is instead of trying to average up, they double up their positions at each new high or low of the market.

Now, this method of scaling in may not be suitable for investors with small capital but large traders with experience of handling risk can make it work quite efficiently. This is how it might happen. A dealer sells 300 million Euros to his clients when EURUSD is at 1.3000. Suddenly there is some news and the EURUSD rate jumps to 1.3200. Most of the traders on the wrong side will jump out of the market covering their losses. But not our dealer as he has not spent even a fraction of the capital available to him. He sells 200 million Euros at this point. The rally continues and the EURUSD rate reaches 1.3300 level. Now, those left behind in the market will not be able to bear the pain. They will cover their losses and get out. But not this dealer. He again sells 400 million Euros. Those few left behind who had been long might want to take profit at this level.

Now, what the dealer has done he has lowered his breakeven by two third of the length of the move. His average price is 100X1.3000+200X1.3200+400X1.3300=1.3228. So, the price has to retrace by only one third in order for the dealer to breakeven. This is how parabolic scaling in works. Sounds like martingale! Doubling up at each step. But pro traders play it professionally. Maybe the dealer had $2 billion as his reserve so he was not risking much. Of course this is a hypothetical example, just to make a point that why the one third and the two third levels that correspond so well with the Fib Levels is the natural level in the currency market.