How to trade using Fibonacci retracements

In this guide, we'll explore the origins and applications of Fibonacci retracements in financial markets, to help you make more informed trading decisions.

What are Fibonacci retracements?

Fibonacci retracement levels are horizontal lines that indicate where price reversals are likely to occur and are part of technical analysis. They are based around the Fibonacci sequence, a pattern of numbers, each representing the sum of the previous two. A Fibonnaci trading strategy would incorporate these levels to analyse price behaviour.

The Fibonacci sequence starts 1,2,3,5,8,13,21,34,55 and continues to infinity, with each number being the sum of the two preceding numbers. If you want to find the next Fibonacci number, you multiply it by 1.61 to go up, or by 0.61 to go down. 

Highlights

Although the Fibonacci sequence was first identified by the Italian mathematician after whom they are named in 1202, the first person to develop the idea of using Fibonacci numbers in finance was Charles Dow, founder of the Dow Jones Industrial Average. 

He noted that, after moving along with the main trend, a price often retraces before resuming its prior movement. He concluded that the latitude of this retracement was between 33% to 66%.

The concept was later refined by stock market analyst Ralph Nelson Elliott, who brought into play more accurate retracement levels: 

• Based on the Fibonacci sequence: 38.2%, 61.8%

• Based on the stock price tendencies: 50% 

Understanding Fibonacci retracements

The reason why some people use the Fibonacci sequence in trading  is that markets have a tendency to reverse the direction they’re going in at various points on the price chart. In percentage terms, the suggested number is 61.8%, also known as the Golden Ratio. 

Fibonacci retracements can be found by:

1. Taking the highest and lowest points on a price chart and marking those as 100% and 0%. 

2. Mark 61.8% and two other Fibonacci based percentages: 23.6%, the sum of a number in the sequence divided by one three places higher and 38.2%, the sum of a Fibonacci number divided by one two places higher. 

3. Then, there will need to be points at 50% and 78.6%, numbers which, while not correlating to the Fibonacci sequence, often see price reversals. 

Fibonacci extensions

It is worth noting that some traders and analysts use further projections of the sequence, known as Fibonacci extensions, to look at how to take things further. 

The key percentage points of these extensions are:

• 161.8%

• 200%

• 261.8%

Fibonacci trading strategy

Traders can use Fibonacci retracement levels as part of their trading strategies. Here are some examples of how they can potentially utilise a Fibonacci retracement strategy. 

Entry and exit points 

A trader could use Fibonacci retracement levels as potential entry and exit points for trades. Traders could look for a price to retrace to one of the levels on the chart and then look for a price action signal, such as a reversal candlestick pattern or a bullish/bearish divergence, to confirm the potential trade setup. 

Support and resistance levels

Traders could use Fibonacci retracement levels as potential levels of support and resistance in the market. Traders could look for a price to retrace to one of these levels and then look for signs, to confirm the potential trade setup. Traders could then enter a trade in the direction of the trend.

Technical indicators

In conjunction with Fibonacci retracements, indicators could potentially provide a more comprehensive view of the market. For example, traders may use moving averages to identify the trend and then use Fibonacci retracements to find potential levels of support and resistance within that trend. They can also use oscillators, such as the relative strength index (RSI), to confirm potential trade setups identified by the retracements.

Price analysis

Another way Fibonacci retracements could be used with other indicators is by combining them with price analysis. Traders may use Fibonacci retracements to identify potential levels of support and resistance, and then use price action analysis, such as candlestick patterns or chart patterns, to confirm the trade setup.

Incorporating Fibonacci retracements into your strategy

Here are some approaches for using Fibonacci retracements in trading. 

• Trending markets: Fibonacci retracements could be effective in trending markets, as they can help to identify potential levels of support and resistance within the trend. In range-bound markets, they may not be as useful, as the price tends to move sideways rather than retracing.

• Use multiple time frames: It may be valuable to use multiple timeframes when using Fibonacci retracements to get a better understanding of the market. Traders could use higher time frames to identify the overall trend and lower time frames to spot potential trade setups.

• Waiting for confirmation: It may be useful to wait for confirmation before entering a trade based on Fibonacci retracements. This could include waiting for a price action signal or a confirmation from another technical analysis tool.

• Risk management: As with any trading strategy, it's important to use proper risk management when trading with Fibonacci retracements. You should always conduct your own research, remember that markets can move against you, and never trade with more money than you can afford to lose.

Conclusion

In conclusion, Fibonacci retracements could be useful tools for traders. Trading with Fibonacci retracements could be applied to different financial instruments, such as commodities, stocks and shares, forex pairs and indices. They could also be valuable when trading contracts for difference (CFDs). Retracement levels could provide helpful information that may assist a trader decide whether to go short or long on an asset while designing their Fibonnaci trading strategy.

Fibonacci retracements are key levels in a price chart, coming in at 0%, 23.6%, 38.2%, 50%, 61.8%, 78.6% and 100%. It is at these levels that price reversals are common, according to the strategy. These points could be used as entry and exit points, as well as support and resistance levels. Traders could use them in conjunction with technical indicators such as moving averages and the relative strength index (RSI), as well as with price analysis. 

However, remember that they cannot predict the future. Therefore, traders will have to remember to do their own research, understand that markets can move against them and never trade with more money than they can afford to lose. 

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