The purpose of the Fibonacci Retracement Tool is to be able to make a determination as to how far a currency pair is likely to retrace after a strong move in either direction. This is helpful since it will allow us to make an entry decision so we know when to enter (or re-enter) a trade when the overall trend once again comes into play.
Take a look at the historical chart of the EURJPY
On this chart we see a long bullish trend running from the lower left to the upper right of the chart. We would draw the Fib line from the “Swing Low” (the lowest point of the move) to the “Swing High” (the highest point of the move). Our Fibonacci Tool then puts the Fib Levels on our chart. If we are using the Fib Tool in a downtrend, we would do the opposite of the above.
As is noted on the chart, when the pair retraces, it will likely retrace to one of these three levels: 38.2%, 50.0% or 61.8%. We would put the tool to use in a trading scenario by waiting until price action trades to one of those levels and then shows a “bottoming” or stalling pattern…some long wicks or a Morning Star pattern would be a couple of examples.
We could then take a long (buy) position back in the direction of the overall trend with our stop being below the lowest penetration of the Fib level by price.