A Fibonacci retracement refers to a type of technical analysis utilized by traders to forecast possible prices within the financial markets. It uses horizontal lines and percentages plotted on price charts to identify potential resistance and support points. Identifying these areas is essential as it aids in the decision-making process.
Traders can use Fibonacci retracements and ratios to figure out the time to open and close positions as well as when to apply limits and stops to their trading activities. Remember that a Fibonacci line functions as a confirmation tool. Therefore, it is better to use the indicator alongside other technical analysis tools like volume and trend lines. The more confirmation indicators you use, the higher the probability of a stronger trade signal.
Retracement levels come from the Fibonacci sequence, and each level is correlated to a percentage. This percentage represents the size of the move previously retraced by the price. The levels are 23.6%, 38.2%, 61.8%, as well as 78.6%. 50% is also used, although it is not an official Fibonacci ratio.
How Fibonacci retracement works
The Fibonacci indicator is valuable as it can plot between any two major price points, for instance, a high and a low. When this happens, it creates a level between the points. This is how this tool works:
- The percentage retracements pinpoint potential support or resistant points, 100%, 61.8%, 50%, 38.2%, 23.6%. Applying the percentages to the residue of the high and low prices for a selected period results in a set of price objectives.
- Depending on whether the market trend is upward or downward, prices tend to retrace a substantial portion of the prior trend before recommencing the move in the initial direction.
- The counter-trend moves often fall into specific parameters, i.e., the Fibonacci retracement levels.
Drawing Fibonacci retracement levels
Drawing the retracement levels is a straightforward three-step process.
In an upward trend:
- Step 1 – Pinpoint the market direction, in this case, the uptrend.
- Step 2 – Affix the Fibonacci retracement technical analysis tool on the bottom, dragging it rightwards, up to the top
- Step 3 – Track the three possible support levels: 0.236, 0.382, and 0.618.
In a downward trend:
- Step 1 – Pinpoint the market direction, in this case, the downtrend.
- Step 2 –Affix the Fibonacci retracement technical analysis tool on the top dragging it rightwards, down to the bottom
- Step 3 – Track the three possible resistance levels: 0.236, 0.382, and 0.618.
Looking for the confluence of signals will bear better results. Avoid assuming that the market will reverse automatically because a price has reached a Fibonacci retracement. Also, combine this tool with tools like Japanese Candlestick patterns for more reliable results.
How to trade using Fibonacci retracement levels
1. Use retracements as re-entries
Fibonacci levels are most commonly used as a regular retracement strategy. Frequently when traders miss sudden outbursts in the trend like sudden bullish moves, they will attempt to identify re-entries during pullbacks. It is an ideal tool to spot swing points during pullbacks. Using a Fibonacci retracement tool, you can discover re-entries on the pullbacks.
2. Support and resistance
Another way to use Fibonacci retracement is to get a Fibonacci move on a substantially higher timeframe and subsequently move down to the standard timeframe. You can then observe the retracement levels as a support and resistance guide.
3. For take profit orders
The third way for traders to use Fibonacci levels is to take profit orders. This is especially true for extensions, which are ideal for determining a take profit level within a trend. The most popular levels among traders are 161.8 and 138.2. Most reputable trading platforms allow traders to add custom levels.
Limitations of Fibonacci retracement in Stock Trading
Retracements have drawbacks in the real stock market. The following are some of the most glaring limitations:
- Retracement levels only indicate static price levels. Hence, it is impossible to accurately predict whether specific stock’s prices won’t surpass or remain below the predicted levels.
- Because retracement levels are incredibly close to each other, it is usually challenging for an experienced broker to accurately determine the platform from which to forecast a specific stock’s future accurately.
- Overall, several reasons affect the price of a stock. Therefore, when calculating their future, one has to consider these other factors as well.
Remember that because retracement levels do not determine support and resistance values, they should never be the only parameters you take into account.
What is the difference between Fibonacci retracements and Fibonacci extensions?
Fibonacci retracement levels show how deep a retracement can run. On the other hand, extensions indicate where the price goes after a retracement. In simpler terms, the former calculates the retracements in a trend while extensions calculate a trend direction’s impulse waves.
Fibonacci retracement levels are valuable, although they could seem quite intimidating to a nouveau trader. Take some time to learn this technical tool, and with some practice, you will have a better grasp. Also, remember to always confirm other points in your checklist before initiating any trade.