Using Fibonacci Retracement Levels

A popular tool used by many students of technical analysis are Fibonacci retracement levels. These are commonly used to find trade entry points. Unlike pivot points which seek simply to anticipate points of support and resistance, Fibonacci retracement levels calculate where a market is likely to bounce back to (retrace) after a preceding move. After this retracement the market is then expected to resume its original direction.

Fibonacci number Sequence

The Fibonacci sequence is an additive numerical sequence named after Leonardo Fibonacci of Pisa, an Italian mathematician of the late twelfth century. Leonardo analyzed a number of repeatable number formations found within nature to form the Fibonacci number sequence. Fibonacci numbers are formed by adding together the preceding two numbers in a sequence to find the next. For example 1+1=2, 2+1=3, 3+2=5, 5+3=8 etc.

Fibonacci Forex retracement ratios are derived from this numerical sequence. By dividing any number in the sequence by the following number we end up with 61.8. This is referred to as the 'Golden Number.' For example we divide the 3rd number (5) in the above sequence by the 4th number (8) we end up with a ratio of 61.8. This is true of the entire sequence. This is one of the retracement levels that we use in calculating Fibonacci retracement's.

Fibonacci Retracement Levels in Forex

The key to using Fibonacci is in identifying the start and end of major market moves. These two points represent the high and low of the move. In Fibonacci terms, think of these levels as representing 0.0% (the start) and 100.0% (the end) of the move. To confirm the end of a move you can use you use any of your preferred technical indicators or candlestick patterns.

Fibonacci retracement levels occur at defined points of this move: 23.2%, 38.2%, 50.0 % and 61.8% are the most commonly used retracement levels. These levels can easily be calculated by using a Fibonacci calculator. Simply input the high and low of the move into the Fibonacci calculator and click ‘calculate.’

Once the levels are calculated they can then be plotted on your chart and used to find trade entries in one of two ways.

The first way is to trade the retrace or pullback after the initial move. Effectively this is trading a temporary reversal or counter trend move. The second method is to wait for the market to retrace the levels and use this as an entry point to rejoin the original trend.

Below we look at examples of both trading approaches.

Using a Fibonacci Retracement Level To Trade a Pullback

Using Fibonacci to identify and trade pullback scenarios is a common tactic among Fibonacci technical analysis traders.

When trading in this way it is important to locate your stops properly and set realistic targets for taking profit. Th50.0% retracement level is often used as an attainable 'take profit' target and one that works well on the 4 hour chart.

On the EURGBP chart above our initial entry following the high would target the 50.0% Fibonacci retracement level with a stop placed at the limit of the initial move. If the 50.0% retracement target is reached we could then move our stops to break even for a free run at the 61.8% retracement.

In this example, our target at the 50.0% retracement was met although our free run at the 61.8% level was taken out by a market bounce.

A few sessions later we can see that despite efforts to move higher, the pair ends up retracing back to the 61.8% level and subsequently falls to complete a full 100% retracement. It is a common feature of Fibonacci that markets that retrace beyond the 61.8% level, will often tend to retrace the whole of the preceding move.

Using Fibonacci Retracements to re enter a trend

As well as using Fibonacci retracement levels to trade trend consolidations, our next example shows how we can apply a Fibonacci retracement level as a point to re enter prior trends.

We have marked out a move of the 4 hour charts which took the USDCHF from just over 1.06 to 1.0840. The first sign we get of an impending retrace is the long wicked candle on the next four hour bar following the moves high.

In the following hours the market falls back through each of the retracement levels. These limit any additional gains for the duration of the retracement. As we can see from the above example the full 61.8% retracement is just shy of being met.

Failure to break support at the 61.8% level acts provides an entry point to rejoin the prior trend. Here our target would be the previous high recorded by the initial move. This was a particularly profitable move as the market then went on to break the previous high.

Fibonacci technical analysis is like any other technical trading approach in that it provides approximations of market levels rather than absolute targets. Quite why the numbers work is difficult to say. It may well be that the number of traders who watch these levels help to make Fibonacci retracement levels a self fulfilling prophecy. Whatever the reason, Fibonacci retracement levels prove a useful tool addition for every Forex traders toolbox.

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