The Ultimate Guide to Fibonacci Retracement levels
Topics:
- Disclaimer / Introduction
- History of Fibonacci numbers and retracements
- How to draw the Fibonacci levels
- Identifying and trading key Fibonacci levels
- Quarterly ranges, and how to trade them
- Conclusion
Disclaimer / Introduction
All the info you are about to read is for entertainment purposes only and should not be seen as financial advice.
I’ve been using the Fibonacci retracements for well over a year. They’ve been an integral part of my strategies and helped me solidify my perspective regarding key trading zones.
I’ve seen other people use it, I’ve seen different ways of using it. And every single one has his/her draw their own conclusion from it. There isn’t a single way of using it, so my way might not work for you.
Fibonacci retracement levels are horizontal lines that indicate where support and resistance are likely to occur, and they can be used to place entry orders, determine stop-loss levels, or set price targets
Investopedia
History of the Fibonacci numbers and retracements
Knowledge of the Fibonacci sequence was traced back, albeit unconfirmed, to as early as 450 BC in ancient India, and is often associated with the golden ratio, the famous 1.618.
I won’t dive deeper than that historically. It is important however to understand the mathematical reasoning behind it.
The Fibonacci Sequence
The Fibonacci sequence is a sequence where each number is the sum of the two preceding ones, starting from 0 and 1. That is:
For F(0)= 0 and F(1) = 1,
And F(n) = F(n-1) + F(n-2) for n>1
The beginning of the sequence is: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, … and so forth.
But, how does this relate to the Fibonacci retracement you often see and use in trading?
The Fibonacci Retracement Levels
All of these numbers (0.236, 0.5, 0.618, etc..) are calculated by dividing the Fibonacci sequence numbers, or deriving it from them:
- 13/55 = 0.236
- 13/34 = 0.382
- 0.5: MID point, not part of the Fibonacci numbers, but still crucial, especially from a psychological point of view
- 13/21 = 0.618
- 0.786 = square root of 0.618
- 0.886 = square root of 0.7864
- ….
The list goes on.
Most trading platforms offer tools that do this for you.
How to draw the Fibonacci retracement levels
This is entirely subjective to your own reasoning, all you have to do is connect any two points that you view as relevant, typically a high point and a low point, and you go on from there.
But this is when it gets tricky, and most beginners get it wrong. How do you determine the high and low points?
(1) Picking the right timeframe
I usually like to start from a High-Time-Frame (HTF) perspective and move down to lower timeframes.
After you’ve chosen your timeframe, then it’s time to determine key zones and pivots
(2) Determining key pivots and key reversal zones
Determining key pivot points is crucial when you’re trading.
When you’re dealing with HTF Price Action, it is important to at least determine the swing high and swing low, and key areas where price reversed.
Swing Highs and Swing Lows
A swing high is a price peak followed by a decline in price.
A swing low is a price bottom followed by an increase in price.
Key Zones: Supports and resistances
Determining support and resistance AND a reversal in price action is also key if you want to draw the Fibonacci retracements. All you need to do is determine the breakpoints, along with candle closes followed by wicks. The more the better. A rule of thumb is to have at least two or more points that you can connect to form a a high probability support or resistance zone, preferably with deviations.
(3) Drawing and trading with the Fibonacci retracement levels
After you’ve determined the key swings and zones, now you can use the tools provided by your favorite charting software to draw the levels.
All you have to do now is the following:
- If you’re in an uptrend, and you’re expecting a retracement, then connect the upper range to your relevant low point, and the lower range to your relevant upper point. You don’t have to connect the extreme high and low points, but at least two points that make the most sense.
- If you’re in a downtrend then do the opposite: connect the upper range to your high point, and the lower range to your low point.
There isn’t an exact rule for that, but it is important to make sure that the Fibonacci level has some confluence with other factors in your chart.
Here’s an example from my good friend Luka:
Before adjustment:
After adjustment:
Again, It’s important to adjust the Fibonacci level to fit the levels the price has reached, and make them as relevant as possible.
Identifying and trading key Fibonacci levels
Let’s illustrate this with two examples:
Example 1: Fibonacci Retracement with key zones
Notice how Bitcoin was rejected at the upper resistance, the 12174$ price point, with what appears to be a weekly deviation from the upside. Price seems to have held at the 0.786 level, which previously acted as a resistance.
Now, depending on your bias (bullish or bearish), there are two ways you can approach this.
If you’re bullish, then you would long the second retest at the 0.786 level, with aa stop right beneath the most recent wick. You would take profit at the key resistance again. Whether you leave part of your position open is entirely up to you. In any case, you’ve already scored a 4.36R with this trade.
If you got stopped out, then you know with a certain conviction that you are most likely wrong. You can always wait for a weekly close below, but that entirely depends on your risk management.
If you’re bearish, then remember that you will need to flip the Fibonacci retracement tool before determining your stop loss and take profits.
You would wait for either of:
- A bearish retest of the key resistance at the top, where you would take profit at every key level below, namely the 0.236 and 0.382 levels. Then you would re-assess if you keep your position open when you get there.
- Or short a retest of the 0.236 level if we dipped from there. You would take profit on the 0.382, 0.5, and 0.618 levels. Any sign of reversal on any of these levels and you would cut the trade. Notice the placement of the stop loss here, you should wait for a wick above the 0.236 and a close below before entering your trade. Your stop would be above that recent wick.
Example 2: Fibonacci Retracement with Key pivots
Let’s connect the swing high and low as a high and low point of our Fibonacci retracement levels.
Now, there isn’t a hard rule for connecting the exact top and exact bottom, and in most cases, you really shouldn’t.
I’ve modified the chart a bit so we can get clear potential support and resistance areas.
I’m going to annotate the image for further clarification and an easier read.
I’m going to leave an exercise for you. If we dipped and retested the blue box with what appears to be a bearish retest. Where would you put your stop loss and take profits?
If you’ve been following along, you know that a clear invalidation of your trade would be a reclaim of the blue area, your take profit can go as far as the 0.618 and maybe the 0.786 levels if we get there.
Quarterly levels, and how to trade them
I won’t dive deep into range trading. But if you want a deeper dive into range trading, please feel free to check this article here by George.
Let’s say you’re trading bitcoin, you’ve identified the range high and range low.
Let’s draw the quarterly ranges. By quarterly, I mean that we would assume that every 1/4 of a range would be considered a key level. This has a lot to do with market psychology and dealing with common numbers that all the people are familiar with: 0, 0.25, 0.5, 0.75, and 1.
Notice how the price had a certain reaction at every quarter. Every level acted at some point as support or resistance.
This is key if you’re trading within a range, as this allows you to determine potential support and resistance areas, as well as where and when to enter/exit a certain trade.
Based on the above alone, and based on pure price action, I can now plan my trades accordingly.
For example, we notice that the price held at the 0.75 level of the range, breaking the range high would mean that we would go and retest the HTF.
Breaking below the 0.75 and we’re heading to the MID level, which acted as strong support in the past: it is a key area to hold if we want to preserve the Higher Low on the macro. If you’re a swing trader, then the 0.5 area might be an excellent place to go long if held. Break below it, and we can anticipate we will revisit the range low.
Conclusion
The above concepts can be really applied to any time frame. BUT, caution is warranted when using them. As it doesn’t necessarily mean that the price will reach the levels you’re eyeing. The Fibonacci retracement levels should be used in confluence with other confirmations.
Hence, always look for confluence, and make sure the probability of the trade is as high as possible. Exercise proper risk management, and have a clear invalidation plan, but most importantly, have exit strategies.
I hope you enjoyed this article. If you did, make sure to:
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A big thanks to my long-term colleague, friend, and mentor, PlanktonTrader!
Also a special thanks to Crypto yoddha and Luka for their feedback! Make sure you guys give them a follow on twitter!
A big thanks to Investopedia and Trading Strategy Guides for the references.
I’m still learning, and we can never stop learning, and sharing my knowledge is the best way for me to master it, and for you to avoid the mistakes I’ve done or I’m about to do.
