Fibonacci retracement is a common form of technical analysis in the trading world, using ancient mathematical scripts as a template for evaluating price movements and identifying possible levels of support and resistance.
While the mathematical proportions and ratios can be found throughout history and the natural world, affecting everything from the construction of ancient buildings to the shape of snail shells, traders need to understand the concepts behind this retracement if they want to use Fibonacci’s mathematical principles to inform their trading strategy.
What Are Fibonacci Retracements?
In forex trading, Fibonacci retracements refer to established areas of support (where the price stops decreasing) and resistance (when the price stops increasing). These Fibonacci retracement levels are always drawn in relation to the price of the forex asset being evaluated, and each retracement level represents a horizontal line on a trading chart that identifies these levels for analysis purposes.
Fibonacci levels are determined by connecting a trendline between the low and the high. The vertical distance is stratified by these ratios, which are established at 61.8 percent, 38.2 percent, and 23.6 percent. While not an official Fibonacci number, 50 percent is also commonly used as a retracement level through this method of analysis.
While even experts can’t fully explain why these retracement levels are such significant indicators for forex investing, historical chart activity shows these retracement levels offer value in their ability to help traders evaluate price action and predict future price behavior.
Common Uses of Fibonacci Retracements
By using Fibonacci retracements to evaluate price action, traders can identify strategic opportunities to set stop losses, buy orders, target prices, and other transactions. This concept is used in a variety of indicators, including Gartley patterns, Tirone levels, and the Elliott wave theory, among others. After a significant price movement, you will often find resistance and support levels at Fibonacci lines.
It’s important to know that Fibonacci retracement levels aren’t like moving averages, which change over time. Instead, retracements are static price levels that don’t change. What this means is that identification can be inherently simple, allowing traders to react quickly when price levels change. The levels are considered inflection points, meaning that at these points, traders will expect a price action—either a rejection or break in price.
The Role of Fibonacci Retracement in the Creation of a Trading Strategy
There are quite a few different strategies that Fibonacci retracements can be used for. Traders are most familiar with retracement levels of 38.2 percent and 61.8 percent, which, following a bearish or bullish price action, can be used to determine correlation and pullback degrees, as well as a continuation pattern. If the retracement has shown itself to be active in indicating resistance or support levels, then traders can deploy a breakout strategy.
Other strategies that traders can adopt include taking long positions at the 38.2 percent retracement level, with a stop-loss order below the 50 percent retracement level. Alternatively, traders can enter a long position at the 50 percent level, placing a stop-loss order below the 61.8 percent retracement level. Traders can also deploy Fibonacci levels at short order around the peak of a big move, using Fibonacci levels as take-profit marks.
The chart below shows the Fibonacci lines marked in yellow. Note the repeated support at the 50 percent and 61.8 percent lines that could have presented short term buying opportunities:
Traders should keep in mind that while Fibonacci levels are one of the most popular technical indicators available, they are limited in what they can reveal about a trading pair because they don’t consider other variables that affect the price, such as volatility, trading volume, and other important data points. These retracement levels are a pure reflection of an asset’s price in relation to its previous price, so Fibonacci numbers often need to be considered alongside other technical information.
Why Fibonacci Retracements Are Crucial to Every Trader
The Fibonacci retracement concept suggests that markets tend to retrace their own behavior over time. This essentially means that Fibonacci retracements follow a continual pattern. Burton Malkiel, a renowned economist and statistician from Princeton, introduced Fibonacci sequence retracements in his investing book, A Random Walk Down Wall Street. He argued that most price movements, while seemingly random, occur as a natural reaction against a larger price movement when traders are either hesitant or looking to profit.
Retracement can then be estimated, based on vertical lengths of support and resistance levels. Target prices or stop losses are set by traders who use Fibonacci retracements according to the key ratios mentioned beforehand. Their use in trading is rationalized based on empirical evidence and partial blind faith in the ratios themselves. Traders believe that continuation patterns can be measured and evaluated through Fibonacci numbers, and so countertraders can use them to set target prices.
One theory behind Fibonacci retracement usage is that markets are subject to natural laws, just as the humans who guide them are. The theory follows that if this is true, Fibonacci numbers should apply to markets. Fibonacci retracements can, indeed, be seen in not just the forex markets but stocks, commodities, and various other financial markets as well. What you’ll find is that Fibonacci retracements are far-reaching, applicable to various markets and methods of trading.
This makes familiarity with Fibonacci levels one of the most valuable skills a trader can have. No matter where your investment journey takes you, your expertise in evaluating Fibonacci retracement will help you assess trading opportunities.
Managing and molding a forex trading strategy isn’t always the easiest of tasks, but it can be made easier through an appropriate handling of the basics.
The forex market moves in waves, and its patterns repeat over time. Fibonacci levels will often mark reversal points, and by combining Fibonacci retracements with other indicators and strategies, traders can position themselves for better performance and larger margins.
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