The Beginner’s Guide to Technical Analysis Part 4: Fibonacci Levels
You would not think that one of the most popular modern technical analysis tools would be named after a 13th century monk, but then stranger things have happened.
Fibonacci was an Italian mathematician born circa 1170, who introduced the golden ratio to European mathematics.
He also came up with a sequence in which each number, plus the previous number, equals the next number. Thus, the Fibonacci sequence: 1,1,2,3,5,8,13,21 and on it goes forever. His work is interesting for many reasons.
It has interesting applications in algebra and geometry (check out the Fibonacci spiral), as well as describing natural phenomena, such as plants flowering and the way leaves grow on trees.
As far as the markets go, some 20th century traders noticed they could apply Fibonacci’s work for their own purposes. Trends, they found, would often conform to certain Fibonacci ratios such as 38.2%, 61.8% or 161.8%.
How to draw Fibonacci levels on your charts
There are several different methods of drawing Fibonacci levels, and within each method several different approaches.
Let’s look at one of the more common ones here.
First you start by drawing from the high of the move to the low of the move using the Fib tool.
You may also draw retracements from the smaller high/lows.
Ideally you would draw them both. When two Fibonacci levels line up it will create a “confluence” which is a stronger technical pattern.
How many timeframes should you look at, or retracements should you draw? It depends on your objectives for your trading plan. Think about the retracements that are going to be relevant to the moves you want to capture.
For example, if you are looking to capture long-term moves that last for 3 months, there is no point drawing intra-day Fibonacci levels.
You can also draw Fibonacci retracements the other way around. That is from the low to the high. This is also how you draw the extension, so sometimes it can be easier to do it this way. If this were, the case, you would invert the comments about the 38.2% and 61.8% retracements, and ignore the 23.6 in the following section.
While technically less correct, I find this way works well for me. You will need to decide what best fits your beliefs about the market.
The first way traders use Fibonacci levels is to help time our entries when we buy dips or sell rallies.
Buyers will look for a retracement to a Fibonacci level in an uptrend and sellers will look for a retracement in a downtrend.
The main levels that are used for this purpose are 23.6%, 38.2% and 61.8%. 50% is also important, although it is not strictly a Fibonacci level (see below).
At 23.6%, the pullback has not been adequately tested. You would need to be very confident in your trade to buy here.
38.2% is a safer level. It’s more plausible to buy here than at 23.6%, but not without a good reason. Perhaps the currency you’re backing is strong for fundamental reasons, or perhaps you’ve just seen a strong reversal pattern.
The two main places to bet on a trend resuming organically are the 50% and 61.8% retracement levels, as the sellers look to take their short term profits in what is still a bull market.
The next level of 61.8% is one to watch closely. Once a trend has fallen too far below 61.8%, it’s hard to be confident that the buyers will find their feet again. Often, the 61.8% level can be a good place to hide your stop behind after having made a purchase on the 38.2 or 50% levels.
In general, you want to place your stop behind a level below. Just because you expect the price to move upwards doesn’t mean it won’t poke and prod at lower levels, potentially hitting your stop if it’s placed too close to market price.
As the trade progresses for you, you can look to trail your stop by one level, so that you lock in some profits no matter where the price ends up heading.
The 50% retracements
50% retracement is an important level, even if it doesn’t come directly from Fibonacci’s work. Many traders will look for a 50% pull-back so it is of psychological significance.
For trading purposes you can treat the 50% level just like an “official” Fibonacci level.
To create extensions, draw your Fib line the opposite way than you did to get your retracements. In a bull market, you would get extensions by drawing your line from top to bottom.
Extensions help you to plan your exits. These are (again) psychologically significant numbers that market participants tend to respect and plan around time and time again.
161.8% is the first extension. If you have been successful in capturing a move from a retracement level, this is the first level at which it will definitely be tested, and can be a good place to take some profits.
261.8% is the next extension. If the price has made it this far, then it’s again time to think about scaling out or exiting.
423.6% is less commonly used, but if your trade gets here you’ve likely made some serious pips. The chances of a reversal have increased, so you may only want to retain a small portion of your original trade.
Using a retracement as a profit target
You can use previous retracements as profit targets in the short term. If you’re confident the trend has steam left in it, but it has fallen below 61.8%, you can pick off some pips on the way back up to 23.6%.
Alternatively, you may have your eye on a short-term resistance level, such as a double head and shoulders at the 50% retracement from a previous move.
There is no one-size-fits-all approach to trading the markets, and Fibonacci is not a magic bullet. The key is to observe what the market has been doing, as well as what it is doing, and use this to your advantage at all times.
When Fibonacci levels combine with other key levels, this creates higher probability trades, as we just discussed.
If price is poised to break out through the 50% retracement on a daily chart, and through another key level on a short-term chart, this can be considered a higher probability trade since buying is clearly beneficial, at least in the short term.
The same goes when price is hovering around ‘big figures’, and especially support and resistance levels. When two or more psychologically important levels align in the same direction, it adds credence to the idea that the trade will be successful, and removes reasons to think the opposite.
There are no certainties, but if you can learn to spot high value trades and execute them quickly, you will be in a much better position than somebody who takes only mediocre trades.
Fibonacci levels and candlestick patterns
Imagine you’re examining a trend, and the very first thing it does is pull back quickly to the 50% retracement. You watch and wait, and see a stubborn doji form. It just won’t seem to budge.
The next candle drags below the 50% retracement, heading for 61.8%. But it quickly picks back up, and becomes a shooting star. You can have a certain amount of confidence now that the trend is set to resume. Why?
Market participants (big and small) were watching this drama unfold, just like you. They had their Fib lines drawn, just like you. If everybody is watching the sellers run out of steam and exit their positions at psychologically important levels, where is the smart money going to be?
This holds true for almost any reversal pattern. The key is to examine what is going on in front of you, in the context of psychologically important Fib levels, because you know everybody else is watching as well.
You can see here a hammer:
We all want to ride the wave, but in order to do this it pays to know where the wave is, and where it may be heading.
Fibonacci can’t tell you what the future will bring, but that’s not where its value lies. Its value lies in the fact that retail traders and institutions alike are conscious of its importance. In many ways it levels the playing field, because everybody is acting on the same information.
If everybody wants to make money, nobody wants to be wrong. If nobody wants to be wrong, everybody is going to try to be right. If everybody is trying to be right, they will examine the best information they have to hand, and act on it.
It’s not magical or prophetic, but it is an essential window into market psychology, and a way to plan your entries, exits, and opportunities to scale in or out. How will you use Fib levels in your trading plan?
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