Technical Analysis Series — Article #2: Basics of Fibonacci Rectracements

If you’ve ever wondered if there is another tool that can help locate zones of support or resistance, Fibonacci Retracements will be your next strategy to use!

What are Fibonacci Retracements?

Fibonacci Retracements are levels that price action can bounce off of, with it acting as a support when drawn from swing low to swing high, or as a resistance when drawn from swing high to swing low. What sets this tool apart from price action support / resistance is that they allow you to know possible future support / resistance levels that have not been previously defined. As a result, they do not necessarily require previously made price action support / resistance levels for them to work, albeit they can be complementary to each other. These Fibonacci levels can also be used in Elliott Wave Theory, and harmonic patterns.

Tip: Remember to use multiple tools to base your entry levels. The more confirmations the better!

Background

Let’s take a moment to talk about how three of the main retracement levels (0.382, 0.618, 1.618) are found. The Fibonacci sequence is the sum of the last two numbers, 0, 1, 1, 2, 3, 5, 8, 13, 21, and so on. As the sequence continues, the quotient of a number divided by the next number nears 0.618. The 1.618 golden ratio, also referred to as φ (phi) is the inverse / reciprocal of this. For 0.382, the quotient of a number divided by a number two places ahead begins to near 0.382. Although the next ratios are less common, they are three out of the many that are used in trading. For the 0.236 ratio, the quotient of a number divided by a number three places ahead begins to near 0.236. For the 0.786 ratio, it is the square root of 0.618. Finally, the 0.886 ratio is derived from the square root of 0.786.

Why do these levels work? No one knows for sure, however some theorize that they work as when a market falls near a Fibonacci retracement, the dip looks good enough to entice traders to buy. Others also theorize that because many algorithmic trading bots and traders use them, it becomes a self-fulfilling prophecy.

How do we use these levels?

When using these levels, the three main levels to look at are the 0.382, 0.5, and 0.618, however there are many more that we will show as we progress through this educative article. To draw them, start by finding a trend. To identify one, look for a general or major move in price. Once located, place the start at the beginning of a trend, and end where the trend finishes. Let’s look at a few examples.

Tip: In Elliott Wave Theory, trends are also known as waves. Although it won’t be discussed in this educational article, Elliott Wave Theory drastically helps with identifying trends and market structure, making the usage of Fibonacci retracements easier.

Examples

Example 1:

In Gold (XAUUSD), a Fibonacci Retracement is placed from the start to the end of the trend highlighted in purple. It retraced 38.2% of the trend to the 0.382 Fibonacci retracement level, before breaking out. A possible resistance area could be near the 0.618 fib, however there is no guarantee. Always use more than one tool to confirm your analysis.

Example 2:

In General Electric (GE), a Fibonacci Retracement is placed from the start to the end of the trend highlighted in purple. The price action is seen reversing 38.2% of the trend, finding an area of resistance at the 0.382 Fibonacci retracement. However, the resistance doesn’t hold for long before it breaks through and finds resistance at the 0.5 Fibonacci retracement, before having a massive decrease in price.

Example 3:

In another time period in Gold (XAUUSD), a Fibonacci Retracement is placed from the start to the end of the trend highlighted in purple. The price action is seen reversing 38.2% of the trend, finding an area of support at the 0.382 Fibonacci retracement. However, the support doesn’t hold for long before it breaks through and finds support at the 0.786 Fibonacci retracement.

Tip: The two examples above show the importance of having risk management (such as through a stop-loss) while trading. Always aim to first minimize losses, break even, and then maximize profits.

Example 4:

In a shorter time period in Gold (XAUUSD), a Fibonacci Retracement is placed from the start to the end of the trend highlighted in purple. The price action is seen reversing 38.2% of the trend, finding an area of support at the 0.382 Fibonacci retracement.

Example 5:

In Silver (XAGUSD), a Fibonacci Retracement is placed from the start to the end of the trend highlighted in purple. The price action is seen reversing 78.6% of the trend, finding an area of support at the 0.786 Fibonacci retracement.

Now that you know the basics, remember that the trend is your friend. Unless you have a strong reason to believe that the trend will reverse, it’s a safe bet to trade with it!

Sounds Easy?

Don’t be fooled. Trading is not as easy as this, and is a discipline that requires extensive learning. The truth is that 90% of traders lose money. However, with training and proper money management, you can make your way to the top. Hindsight makes these look easier than they actually are, and is why I stress the point that multiple tools should be used to confirm your analysis, and have a trading plan. Always use stop-losses, cut your losses, and move on.

This is the author’s perspective and is meant to be used for educational purposes. This is not financial advice.

Written by Fahim Ahmed, Writer for the Junior Economist