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Lesson 4: Fibonacci Trading

Lesson 4: Fibonacci Trading

Fibonacci retracement levels often indicate reversal points with uncanny accuracy. However, they are harder to trade than they look in retrospect.

The Fibonacci trading tool refers to a tool that measures the size of a price move and subsequently places horizontal support and resistance levels on a price chart. These support and resistance lines are referred to as "Fibonacci retracement" and “Fibonacci extension” levels and are used to make online trading decisions in the same way as normal horizontal support and resistance levels.

About Fibonacci Trading Tool

Fibonacci trading is a technical analysis tool that is widely used by traders and investors alike.

Fibonacci retracement and extension levels provide a valuable kind of support and resistance information that other trend indicators and oscillators don’t. In any financial market, price trends don’t move in a straight line. Instead, trends move in a zigzagging pattern as they periodically retrace parts of their primary move and continue it, steadily testing progressive levels of support and resistance as they move higher or lower.

For example, for a given chart, Fibonacci retracements help us determine where prices are likely to either:

  • Make repeated short-term reversals as they zigzag within their longer-term trend.
  • Make a longer-term reversal within an even longer-term trend or begin a longer-term reversal.

Fibonacci retracement and extension levels are based on certain mathematical relationships, expressed as ratios, between numbers in a series, that were identified (at least for the Western world) by thirteenth-century mathematician Leonardo Fibonacci. They have applications in fields as diverse as biology, music, and art.

Traders found that trends tend to retrace prior moves according to these same ratios, which in percentages come to 23.6 percent, 38.2 percent, 50 percent, 61.8 percent of a given trend. By drawing these percent retracements of a trend on their charts, they could better predict where future price moves might stall or reverse. That is, they found that when trends retrace, they tend to retrace 23.6 percent, 38.2 percent, 50 percent, 61.8 percent, or 100 percent of their prior move. It’s unclear why these ratios work, but they do, so they became widely accepted, thus strengthening their influence as markets accept them as likely support/resistance points.

The Fibonacci trading tool is not only used to establish the retracement levels for traders as support or resistance; it can also project extension levels that show where the price could go to. Fibonacci extensions can, therefore, be used for setting Take-Profit and Stop-Loss levels or even for counter trend entries.

The most common extension levels used by traders are the 138.2% and 161.8% levels, although there are many other extension levels used by different traders.

Let’s see how to use Fibonacci trading tools and how well these levels predict support and resistance lines.

How to use Fibonacci Retracement Correctly

With Fibonacci retracements, however, it’s worth reviewing the general mechanics of how you get them on your chart. So, where did these lines come from? How do you draw them?

To use Fibonacci retracement correctly, you select a major high and low for the period in question. Your charting software divides that price range by the key Fibonacci ratios of 23.6 percent, 38.2 percent, 50 percent, 61.8 percent, and 100 percent, and it draws horizontal lines at the prices that correspond to these percentages of that range. These price levels are where support/resistance lines are more likely to occur. Your trading platform or trading app will describe the mechanics of this, which typically involve nothing more than the following procedure steps: Identify the price range to study.

To plot the Fibonacci retracements for an uptrend that occurs after a downtrend, you first need to define the range of the prior downtrend so that the charting software can calculate the percent retracement points that the new uptrend will hit as it retraces through the range of the prior downtrend.

  • To do that: Place your mouse cursor at the high point where the downtrend began, left click and hold the left mouse button down in order to drag the mouse cursor to the low point where the downtrend ends, then release the left mouse button. The fib retracements will appear. These serve as support/resistance points for the uptrend that follows. As price rises, each level it approaches is resistance until decisively breached, and then that level becomes support unless the price falls back below it.

To plot the Fibonacci retracements for a downtrend that follows an uptrend, you do the same thing. The only difference is that you first need to define the range of the prior uptrend so that the charting software can calculate the percent retracement points that the new downtrend will hit as it retraces through the range of the prior uptrend.

  • To do that: After selecting the Fibonacci Retracements option from your menu, place your mouse cursor at the low point where the uptrend began, left-click, and hold the left mouse button down to drag the mouse cursor to the high point where the uptrend ends, then release the left mouse button. The fib retracements will appear. These serve as support/resistance points for the downtrend that follows. As price falls, each level it approaches is supported until decisively breached, and then that level becomes resistance unless the price falls back below it. The software fills in the price levels that correspond to 23.6 percent, 38.2 percent, 50 percent, 61.8 percent, and 100 percent of the price range you selected.
Fibonacci Retracement
Source: CAPEX WebTrader

Fibonacci retracement levels help to provide price levels of support and resistance where a reversal in direction could take place and can be used to establish entry levels. The retracement levels are based on the prior move in the market:

  • After a big rise in price, traders will measure the move from bottom to top to find where the price could retrace before bouncing higher and continuing in the overall trend higher (see chart above).
  • After a big fall in price, traders will measure the move from top to bottom to find where price could retrace before correcting lower and continuing in the overall trend lower (see chart below).
Fibonacci extension
Source: CAPEX WebTrader

Fibonacci trading levels are automatically placed

As you can see in the charts above, after the Fibonacci tool has been applied, it automatically places the Fibonacci levels between the start and the end of the move. These levels are referred to as “Fibonacci retracement” levels.

Fibonacci levels are shown as percentages of that total move. So, the level that has been placed halfway between the start and the end of the move is the 50% retracement level. So if the price then retraced halfway back, it is said to have retraced to the 50% level. This then acts as support or resistance, depending on which way the trend is.

The retracement levels, therefore, tell us how far the pullback could be.

In the chart below you can see the 38.2%, 50% and 61.8% levels. These are commonly used levels that the price could retrace back to, although there are other retracement levels that have been identified and work well.

Fibonacci trading
Source: CAPEX WebTrader

Fibonacci retracement levels can be used for entries

As you can see from the first chart above, the Fibonacci tool was applied to an uptrend and the 38.2%, 50%, and 61.8% levels were placed in between the start and the end of the move. As these are levels that the price could retrace back to, you can then use them for potential entries.

  • Potential long entry at 61.8%
  • Potential long entry at 50.0%
  • Potential long entry at 38.2%

How to choose the correct Fibonacci retracement level to enter

There are two ways to choose which retracement levels you use to enter into the markets:

1. Aggressively enter as the price reaches each level.

You could enter at each retracement level placing a stop loss on the other side of the Fibonacci level. If your stop-loss is hit, you simply enter again at the next level and carry on until the price goes back in your favour. This is an aggressive way of finding entries using the Fibonacci trading tool.

2. Wait until the price finds support or resistance at these levels first, and then enter.

You wait until the price finds support or resistance at these levels, wait for the price to move back in the original direction of the trend, and then enter.

It is important to note that Fibonacci is not a trading system in itself – it must be used in conjunction with or as part of a trading strategy, either short-term like scalping, day trading, arbitrage, or longer-term like swing trading or position trading.

You can take a position on Fibonacci trading levels with a CFD account. These financial products are derivatives, meaning they enable you to go both long or short on an underlying market.

As a result, you can use CFDs (contract for differences) during both a Fibonacci retracement and a Fibonacci extension. With a Fibonacci retracement, you could use CFDs to open a long position after the first retracement, and with a Fibonacci extension, you use them to close the position after the new high and seek opportunities to go short.

Follow the steps below to trade a Fibonacci retracement or a Fibonacci extension:

  • Access CAPEX WebTrader and research the markets you can trade
  • Practice trading with a demo account and see how well these levels predict support and resistance lines.
  • Create a live account when you’re ready to trade the live markets

How to use Fibonacci extension levels

The Fibonacci trading tool is not only used to establish the retracement levels for traders as support or resistance; it can also project extension levels that show where the price could go to. Fibonacci extensions can, therefore, be used to determine stop-loss and take-profit levels or even potential entry levels for counter-trend movements.

The most common extension levels used by traders are the 138.2% and 161.8% levels, although there are many other extension levels used by different traders. The following is an example of extension levels in a downtrend.

Fibonacci extension
Source: CAPEX WebTrader

The Fibonacci trading tool can be used to enter a position at one of the retracement levels when the price pulls back and then exit at one of the extension levels.

Extension levels of the Fibonacci trading tool can be applied to an uptrend for:

  • Potential long entry at a retracement level
  • Potential exit at an extension level

How to choose the extension level to determine Take-Profit levels

The extension levels can be matched to the corresponding retracement levels to maximize profitability. For example, if the price retraced to the 38.2% retracement level, then the related extension level would be 138.2.

  • Short entry at 38.2% retracement level
  • Corresponding extension level at 138.2%

The related extension to the 50.0 or 61.8 retracement level is 161.8.

  • Short entry at 50.0% retracement level
  • Corresponding extension level at 161.8%

The first question you may ask is “why do Fibonacci retracement and extension levels correspond with each other?.” The answer comes back to a self-fulfilling prophecy. Banks and large financial institutions will look to take their profit at some point and targeting a Fibonacci extension level is one method they use. They will be expecting other banks and traders to exit at these levels and so based on these expectations, they do the same – hence a self-fulfilling prophecy.

However, it is important to note that this is not a fixed rule; for extension levels to work, they must be in a confirmed trend, and this does not happen every time.

Using each level as a target

An easier method of using the extension levels is simply to exit when the price finds significant support or resistance there. In other words, if the price seems to have trouble breaking through a Fibonacci trading level, then this can be deemed a good exit.

Limitations of 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. Therefore, other confirmation signals are often used, such as the price starting to bounce off the level.

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

Final words about Fibonacci Trading

Traders must choose the period to which they apply Fibonacci trading tools to their charts, so there is a degree of human judgment as to the range to which a given set of Fibonacci levels will be applied. At any one time, millions of traders will be looking at different Fibonacci levels for different periods and time frames. So, it’s helpful to draw Fibonacci retracements and extensions for a time frame above and below the one from which you trade and in combination with other technical trading indicators.

Bollinger Bands are a popular choice among Fibonacci traders because of their ability to confirm breakouts based on an asset's current trading range. Congestion from a Fibonacci retracement can be seen as particularly telling if the upper and lower Bollinger Bands have been contracting at the same time, confirming the likelihood of a breakout.

The moving average convergence divergence (MACD) is also a good fit with Fibonacci analysis. The MACD shows the relationship between two different moving averages. Traders use these two moving averages to spot crossovers, divergences, or trends with significant momentum. Those who prefer RSI or stochastic oscillator for trend confirmation can employ those instead of the MACD.

The Fibonacci retracement strategy can play the support role in many different breakout trading systems, helping to identify natural exits or stop loss placements. These signals can be even stronger if the asset has some natural Fibonacci clusters around certain support or resistance lines.

This helps you to differentiate between a normal post-movement retracement and a change in trend.

Discover how to trade with CAPEX Academy, using our series of interactive courses about technical analysis.

FAQs:

Who is Fibonacci?

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.

What is a Fibonacci sequence?

The Fibonacci sequence is a series of numbers where the next number is simply the sum of the two preceding numbers. So, 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.

What is Fibonacci's golden ratio?

The golden ratio is the most important part of Fibonacci's work. Any number in the series divided by the previous number gives us 1.618 as we get further down the series. There are plenty of examples in nature adhering to this ratio (or the inverse of the number, 0.618). For example, if you divide the number of female bees by male bees in a hive, you will get 1.618 as the answer. For sunflowers, each new seed is 0.618 of a turn from the last one. Fibonacci also applies to humans as well. There are lots of instances of this golden ratio working in relation to our bodies: one example is the ratio of the length of your forearm to your hand, which is 1.618.

What is the Fibonacci sequence used for?

The Fibonacci sequence and golden ratio appear frequently in nature, biology, architecture, and fine art. It is seen in flower petals, tree branches, human DNA, and population growth. The golden ratio and other Fibonacci ratios are also often found in the financial markets, and they form the foundation of the Fibonacci retracement tool.

What is Fibonacci Retracement?

Fibonacci retracement levels often mark retracement reversal points with surprising accuracy. The retracement levels are a powerful tool that can be applied to all timeframes, including day trading and long-term investing. Fibonacci numbers also play a crucial role in the Elliott Wave principle, a technical analysis tool used to identify market cycles. The tool can be used across many different asset classes, such as foreign exchange, shares, commodities, and indices.

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Users/readers should not rely solely on the information presented herewith and should do their own research/analysis by also reading the actual underlying research. The content herewith is generic and does not take into consideration individual personal circumstances, investment experience or current financial situation.

Therefore, Key Way Investments Ltd shall not accept any responsibility for any losses of traders due to the use and the content of the information presented herein. Past performance and forecasts are not reliable indicators of future results.
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