How To Use Fibonacci Retracement Levels in Trading?

Many traders rely on Fibonacci retracements, a technical analysis, to foretell where prices may go in the stock market. With proper application, Fibonacci ratios and retracements may aid traders in predicting future price levels of support and resistance by analyzing historical data.

Keep in mind that the Fibonacci sequence is just a supporting indicator. Trend lines, volume, MACD, and moving averages are other technical analysis tools that work well with this indicator. In general, a stronger trade signal is usually associated with a higher number of confirming indications. 

This article will delve into Fibonacci retracement concepts and steps to trade with Fibonacci retracement levels.

What Is Fibonacci Retracement Levels?

Fibonacci retracement levels are horizontal lines on a price chart used in technical analysis to identify potential support or resistance levels in a financial market. These levels are based on key mathematical ratios derived from the Fibonacci sequence, a series of numbers where each number is the sum of the two preceding ones.

Alt: Fibonacci Retracement Levels in The Chart

The main Fibonacci retracement levels include:

• 23.6%
• 38.2%
• 50%
• 61.8%
• 78.6%

These levels are drawn by connecting a significant low to a significant high (in an uptrend) or a significant high to a significant low (in a downtrend). Traders use these levels to assess potential reversal points or areas where the price may experience a pullback before continuing its trend.

The ratios associated with these levels (23.6%, 38.2%, etc.) represent the percentage of the previous price movement that may serve as a retracement. For example, a 38.2% retracement level suggests the price might pull back 38.2% of the previous move.

Read More: What Is SMC (Smart Money Concepts) In Forex Trading?

Use Cases for Fibonacci Retracement Levels

There are many uses for Fibonacci retracement levels in trading:

• Entry Orders: Fibonacci levels are used by traders to set entry orders. Traders may see a retracement to the 61.8% level as a potential buying opportunity if a stock has recently been rising and then begins to climb again.
• Determine Stop-Loss Levels: Fibonacci levels are useful tools for achieving this goal. One common practice among traders is to place a stop loss order precisely below the Fibonacci level at which they want to initiate a position after a rebound. It would be an indication of a failed rally if we break below.
• Price targets: Fibonacci retracement levels are sometimes used by traders to establish price objectives. A trader may aim for a price around the prior high, for instance, if a stock is rising and then retraces to the 38.2% mark before continuing to rise.

Time To Read: 7 Basic Concepts of Market Behavior ( Uptrend, Downtrend, and Ranging Market)

Example of Fibonacci Retracement Levels in Trading

Let’s pretend an asset’s price goes from $80 to $120 over time. Find the spread between the high and low prices to draw the retracement levels: Diminishing $120 by $80 yields $40. Next, add the low price to the product of this difference and the three critical Fibonacci ratios (0.382, 0.5, and 0.618):

• 38.2% retracement level: $80 + ($40 x 0.382) = $94.48
• 50% retracement level: $80 + ($40 x 0.5) = $100
• 61.8% retracement level: $80 + ($40 x 0.618) = $105.52

When shown horizontally on a chart, these levels represent either support or resistance. Traders may think about getting in a long or short position, depending on the direction of the price, if it retraces and hits one of these levels.

A real market situation may seem different, so keep that in mind as you consider these figures. Since it is so flexible, you may use the Fibonacci retracement tool with various financial instruments and periods.

Golden Ratio in Fibonacci Retracement Levels

In trading, the Golden Ratio is often applied through Fibonacci retracement levels, derived from the Fibonacci sequence and incorporating the Golden Ratio (approximately 1.61803398878) and its related ratios. Traders and analysts widely use these levels to identify potential support and resistance levels in financial markets.

The primary Fibonacci retracement levels that incorporate the Golden Ratio are:

• 38.2%: This level is derived from dividing a number in the Fibonacci sequence by a number that is two places to the right. The result is approximately 0.382, and its inverse is the Golden Ratio.
• 50%: Although not a strict Fibonacci level, 50% is often considered due to its significance as a psychological midpoint between the high and low of a price movement.
• 61.8%: This level is derived similarly to the 38.2% level but using a number three places to the right in the Fibonacci sequence. The result is approximately 0.618, the inverse of the Golden Ratio.

Note: While the Golden Ratio and Fibonacci retracement are popular tools, they could be more foolproof and should be used with other forms of analysis for comprehensive decision-making.

Learn The Market: What Is Fair Value Gap (FVG) [Imbalance, Inefficiency in Trading 2023]?

History of Fibonacci Numbers or the “Golden Ratio”

Leonardo of Pisa, better known by his nickname “Fibonacci,” was an ancient mathematician whose work laid the groundwork for both the golden ratio and the Fibonacci sequence. Known today as the Fibonacci sequence, he first published it in 1202 in his book “Liber Abaci.” 

Each successive number is the product of the two numbers before it in the series, which begins with 0 and 1. Plant and animal development patterns are only two examples of the numerous natural occurrences that display this cycle.

How Does Fibonacci Retracement Work?

Let’s break down how Fibonacci retracement works:

1- Understanding Fibonacci Numbers

• The Fibonacci sequence is a series of numbers where each number is the sum of the two preceding ones: 0, 1, 1, 2, 3, 5, 8, 13, 21, and so on.
• Traders use specific ratios derived from this sequence: 23.6%, 38.2%, 50%, 61.8%, and 78.6%. These are called Fibonacci retracement levels.

2- Identifying Trend Reversal Points

• When a financial asset (like a stock or currency) is trending, it often experiences retracements or pullbacks before continuing its trend.
• Fibonacci retracement levels help traders identify potential support or resistance levels during these pullbacks.

3- Drawing Fibonacci Retracement Lines:

• Imagine a stock’s price increased from $20 to $25. Traders draw a line from the lowest ($20) to the highest ($25) point.
• Along this line, horizontal lines are drawn at the Fibonacci retracement levels (23.6%, 38.2%, 50%, 61.8%, and 78.6%).

4- Calculating Retracement Levels:

• To calculate retracement levels, traders look at the difference between the highest and lowest points.
• Using the example, if the price increased by $5, the 23.6% retracement level is calculated by multiplying $5 by 0.236, giving $1.18.
• Subtracting $1.18 from the peak price ($25) gives the 23.6% retracement level at $23.82.

5- Repeating for Other Levels:

Traders repeat this process for other Fibonacci levels, helping them identify potential levels where the price might reverse or find support.

6- Decision-Making in Trading:

Traders use these retracement levels as guides for making decisions. For example, they might consider buying or selling at these levels based on other technical indicators or their overall strategy.

Learn More: From Novice to Pro: Your Roadmap to Famous Price Action Patterns

The Most Used Numbers Fibonacci Retracement Level

In trading, Fibonacci retracement levels are derived from the Fibonacci sequence, but traders use the ratios or differences between these numbers. Here are some examples:

23.6%:

• Example: 13/55=0.2364 (rounded to 23.6%)
• This ratio is often considered a shallow retracement level.

38.2%: 

• Example: 21/55=0.3818 (rounded to 38.2%)
• Traders use this level to identify a moderate retracement within a trend.

50%:

• Example: 34/55=0.5455 (rounded to 50%)
• While not a traditional Fibonacci level, traders often include it as a psychological midpoint.

61.8%:

• Example: 34/55=0.6182 (rounded to 61.8%)
• Widely considered a key Fibonacci retracement level, indicating a potential reversal point.

78.6%:

• Example: 55/89=0.6179 (rounded to 78.6%)
• Another important retracement level, especially in trend analysis.

Minor Level – 50%:

• Example: 21/34=0.6176 (rounded to 61.8%)
• Although considered minor, 50% is often used by traders for potential support or resistance.

The primary levels are 23.6%, 38.2%, 50%, 61.8%, and 78.6%; however, more levels may be included for more detailed analysis if traders want. One possible use of these ratios is pinpointing a financial asset’s possible support or resistance levels.

How to Trade Using Fibonacci Retracements Levels?

Using Fibonacci retracement levels in trading involves identifying potential levels of support or resistance based on the Fibonacci ratios. 

Let’s walk through an example of using Fibonacci retracement levels in trading with a currency pair. Imagine you are analyzing the EUR/USD (Euro/US Dollar) on a daily chart:

Alt: Trade Using Fibonacci Retracements Levels

1- Identify a Trend

Determine whether the market is in an uptrend or downtrend. Fibonacci retracement is typically applied to existing trends.

• Example: Suppose you observe that the EUR/USD has been in a clear uptrend for the past few months.

2- Select Swing High and Swing Low Points

In an uptrend, identify the swing low (lowest point); in a downtrend, identify the swing high (highest point). These points help establish the range for applying Fibonacci retracement.

• Example: Let’s say the swing low is 1.1000, and the swing high is 1.1500.

3- Draw Fibonacci Retracement Lines

Use a charting platform to draw Fibonacci retracement lines from the swing low to the swing high (in an uptrend) or from the swing high to the swing low (in a downtrend).

• Example: In your charting tool, fit the swing low (1.1000) to the swing high (1.1500) using Fibonacci retracement lines.

The major Fibonacci retracement levels will be at:

• 23.6%: 1.1000+0.236∗(1.1500−1.1000)=1.1136
• 38.2%: 1.1000+0.382∗(1.1500−1.1000)=1.1232
• 50%: 1.1250 (midpoint between 1.1000 and 1.1500)
• 61.8%: 1.1000+0.618∗(1.1500−1.1000)=1.1364
• 78.6%: 1.1000+0.786∗(1.1500−1.1000)=1.1448

4- Interpret the Levels

If the EUR/USD experiences a pullback, these Fibonacci levels can be potential support levels.

• 23.6% and 38.2%: These levels are considered shallow retracements. Traders may see them as potential support or resistance levels within the trend.
• 50%: Although not a traditional Fibonacci level, it’s often included for its psychological significance. Traders watch this level for potential reversals.
• 61.8% and 78.6%: These are significant retracement levels. Traders closely monitor a bounce or reversal near these levels.

5- Confirm with Other Indicators

Use Fibonacci retracement levels in conjunction with other technical indicators like moving averages, trendlines, or candlestick patterns to increase the reliability of your analysis.

6- Set Entry and Exit Points

Set entry and exit points for your trades based on the interpretation of Fibonacci retracement levels and other indicators.

• Example: Consider entering a trade near a Fibonacci support level in an uptrend or exiting near a Fibonacci resistance level. Suppose the price retraces to the 38.2% level (1.1232) and shows signs of bouncing back. You might consider entering a long trade with a stop-loss below the 50%.

7- Risk Management

Always implement money and risk management strategies, such as placing stop-loss orders, to protect your capital in case the market moves against your expectations.

8- Practice and Monitor

• Practice using Fibonacci retracement on historical charts to gain confidence.
• Regularly monitor your trades and adjust your strategy based on market conditions.

Pros and Cons of Using Fibonacci Retracement

Pros	Cons
A useful tool for identifying possible levels	Has the potential to incorrectly determine appropriate amounts
Easy to use	Based on historical data
Objective	Too popular, losing predictive power
Popular	Subject to market volatility

Pros of Fibonacci Retracement Levels

1. Find Important Levels: Helpful for finding possible levels of support and resistance, which traders may use to make better decisions.
2. User-Friendliness: The strategy is straightforward and quick to replicate, making it relatively easy for traders to understand and execute.
3. Reasonable: This method offers objectivity by relying less on gut feelings and more on mathematical ratios.
4. Notoriety: Its support and resistance levels may become true to themselves due to its extensive usage.

Cons of Fibonacci Retracement Levels

1. Concerns About Accuracy: When used alone, they increase the likelihood of incorrectly estimating price changes.
2. Historical Data Reliance: This method depends only on past data, which may not be a reliable indicator of future price movements.
3. Market Volatility: It is difficult to accurately forecast support and resistance levels when market volatility is not considered.

How To Draw Fibonacci Retracement Levels?

Drawing Fibonacci retracement levels is a simple three-step process. Let’s break down the process of drawing Fibonacci retracement levels more clearly:

In an Uptrend

1. Identify the Uptrend: Look at the price chart and identify an uptrend where prices are generally higher.
2. Attach Fibonacci Tool: Use your charting platform to attach the Fibonacci retracement tool. Place one end of the tool at the bottom of the uptrend and drag it to the top, covering the entire upward price movement.
3. Monitor Support Levels: The Fibonacci retracement tool will automatically generate 23.6%, 38.2%, and 61.8%. The price might find support during a pullback at these potential support levels.

In a Downtrend

1. Identify the Downtrend: Identify a downtrend on the price chart, where prices generally move lower.
2. Attach Fibonacci Tool: Attach the Fibonacci retracement tool at the top of the downtrend and drag it to the bottom, covering the entire downward price movement.
3. Monitor Resistance Levels: The Fibonacci retracement tool will automatically generate 23.6%, 38.2%, and 61.8%. These are potential resistance levels where the price might face resistance during a retracement.

Tips for Using Fibonacci Retracement Levels in Trading

1. Incorporating Fibonacci levels into several forms of technical analysis makes them more than just a solitary tool. For example, after large market fluctuations, Elliott Wave theory and Gartley patterns often pinpoint possible reversals around certain Fibonacci levels.
2. Traders can use Fibonacci retracement levels and other analytical tools to improve their market research.
3. Although the levels are helpful, they are not infallible. Before basing trading choices on Fibonacci retracement, it is crucial to consider other indications and considerations.
4. To know how to read Fibonacci retracement levels, you need to know the market and the trend.
5. Look for a confluence of signals before making trading decisions. Please don’t rely solely on Fibonacci levels; consider combining them with other technical analysis tools. For example, observe Japanese Candlestick patterns check oscillators, and indicators for additional confirmation.
6. Be cautious about assuming automatic reversals because the price reaches a Fibonacci level. Confirm the signals with other indicators for a more robust analysis.
7. The chart shows the “Three White Soldiers” pattern, confirmed by prices trading above the Moving Average line and the MACD indicator above the zero line. Combining these signals strengthens the trading decision.

Conclusion

When looking for support and resistance levels, traders often turn to Fibonacci retracements. The data collected allows traders to establish price goals, create stop-loss levels, and place orders. Although Fibonacci retracements might be helpful, traders often rely on other indicators for more precise trend evaluations and improved trading choices.