Fibonacci retracements

Introduction

Leonardo Fibonacci was a mathematician born in 1170 AD. From his work, we get the Fibonacci sequence of numbers and the well-known Fibonacci golden ratio. The Fibonacci sequence is a series of numbers where the next number is the sum of the two preceding numbers. For example, it would run 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, and so on, with the sequence continuing indefinitely.

Fibonacci retracement levels stem from the Fibonacci sequence. They are horizontal lines that indicate where support and resistance are likely to occur. The Fibonacci retracement levels are all derived from the number string noted above. 

After the sequence gets going, dividing one number by the next number yields 0.618, or 61.8%. Divide a number by the second number to its right, and the result is 0.382 or 38.2%. All the ratios, except for 50% (since it is not an official Fibonacci number), are based on some mathematical calculation involving this number string.

Understanding how market prices move 

Price does not move in a straight line but instead in a zigzag way. It moves strongly in one direction and corrects some of that movement in the opposite direction, as shown in Figure 1. 

Figure 1

Why traders use Fibonacci retracement levels

Traders use Fibonacci retracement levels to forecast when price corrections will end and start an uptrend (Figure 2), or when sellers will enter the market and start a downtrend (Figure 3).

Figure 2

Figure 3

How do you draw Fibonacci retracement levels?

In the uptrend, we draw retracement from major trough to major peak, as shown in Figure 4, and in the downtrend, we draw from major peak to major trough, as shown in Figure 5.

Figure 4

Figure 5

How to use the Fibonacci retracement in trading

Fibonacci retracement lines are often used as part of trend-trading strategies. If a retracement is taking place within a trend, you could use the Fibonacci levels to place a trade in the direction of the underlying trend. 

The idea is that there is a higher chance a security’s price will bounce from the Fibonacci level back in the direction of the initial trend. By plotting Fibonacci ratios such as 61.8%, 38.2%, and 23.6% on a chart, traders may identify possible retracement levels and enter potential trading positions.

Using the Fibonacci retracement in an uptrend

During an uptrend, buyers have total control over prices, and prices make higher highs and higher lows. When prices form a higher high, some traders begin to take some profit from their winning positions, forcing prices to decline and move downward. 

This movement is called a correction. The trader will wait for any reversal candlestick pattern around any Fibonacci retracement levels to buy again during the uptrend, as shown in Figure 6 and Figure 7.

Figure 6

Figure 7

Using the Fibonacci retracement in a downtrend

During downtrends, sellers have total control over prices, and prices make lower highs and lower lows. When prices form a lower low, some traders begin to take some profit on their positions, forcing prices to rise and move upward. 

This movement is called an upward correction. The trader will wait for any reversal candlestick pattern around any Fibonacci retracement levels to sell again during the current downtrend, as shown in Figure 8 and Figure 9. 

Figure 8

Figure 9

Limitations of Using Fibonacci Retracement Levels

While the retracement levels indicate where the price might find support or resistance, there are no assurances the price will stop there. This is why other confirmation signals are often used, such as the price starting to bounce off the level. 

Another argument against relying heavily on Fibonacci retracement levels is that there are so many of them that the price is likely to reverse near one of them often. The problem being that traders struggle to know which one will be useful at any time. When it doesn't work out, it can always be claimed that the trader should have been looking at another Fibonacci retracement level instead.

Conclusion

Fibonacci retracements are useful tools that help traders identify support and resistance levels, but traders must use other technical tools with them to ensure they’re making the best trading decision.