Fibonacci Retracements

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In this lesson, we discuss another important indicator we use in our trading the Fibonacci retracements. The Fibonacci sequence is used in technical analysis to locate support and resistance areas. On charts, each level is represented by a percentage retracement of the price from its previous high or low. Before we begin, let us understand what retracements are. As already discussed, during the course, the price moves in trends.

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But the price does not move in one direction and tends to return to the average. Its movement is never vertical. So during a trend, the price tends to retrace. These are temporary price corrections that occur in both an uptrend and a downtrend. In most cases, they do not represent trend changes.

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The price during a trend continues its direction. Using retracements allows us to enter a position with a better price and benefit from the trend. When the price starts an uptrend, it reaches higher highs. More traders notice this movement and enter the market. The price keeps going up.

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The more the price rises, the more traders will try to exit the market to take profits. This may result in a temporary sell off. The trend then restarts its path until the trend runs out. So where are Fibonacci retracements coming from? The Fibonacci sequence was born around 1200 by the mathematician Leonardo Pisano, also called Fibonacci.

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His discovery was a revolution in mathematics. Let's try to understand his discovery and what it means for finance. The Fibonacci sequence is a sequence of positive integers where each number is the sum of the previous two. This series can go on forever. Each number of the series added to the previous one will result in the next one.

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Each number has a ratio to the next1 of 1.618, or also called the golden ratio. This coefficient is the basis of Fibonacci retracements. Now let's look at how best to use this tool in a trading strategy. The ideal strategy is to buy a pullback in an uptrend and sell a rally in a downtrend. The underlying idea is that in a trend, the price tends to retrace towards the mean for a percentage of its movement before continuing its move in the direction of the trend.

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But how can we identify these entry and exit levels? The most commonly used retracement levels are as follows. 23.6% or 0.236, 38.2% or 0.382, 50% or 0.5 and 61.8% or 0.618. One of the most significant levels is 0.5. We also use 0.618 as the last level before a trend reversal.

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The 0.5 level is used to spot a potential trend reversal start. To draw a Fibonacci on the graph, you need to identify a swing high and swing low point. In an ongoing trend. A swing high is the highest price value in a given period of time. A swing low is a lower price value given a specific period of time.

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To draw Fibonacci in a chart, we can use Trading view. Here on the left we can access the Fibonacci retracement tool. Now we can draw it on the chart. In an uptrend, we need to look for a swing low like this one. The price has started a new uptrend.

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We then want to locate a swing high and define our levels of entry. The the idea is that we want to find an efficient entry during an uptrend for a long position by using the Fibonacci retracements levels. As you can see, the price retraces to these levels and then continues its upward move. By entering along at the Fibonacci level here, we would have made a profit and benefited from the continuation of the trend. We can do the same in a downtrend.

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Here we are looking for a pullback in the trend. For a potential short entry in a downtrend, we need to look for a swing high. This is where we can start drawing our Fibonacci retracement. We then need to connect the swing high with the swing low like in this case. Now we have our Fibonacci levels.

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Let's look at what happens in the price. The price retraces back to our Fibonacci levels, giving an efficient potential short entry. Then the price continues its downward move. To recap, this is how we can draw Fibonacci levels. STEP 1.

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Choose a chart of a stock, currency, commodity or any other traded instrument. This chart should display historical price data. We typically draw Fibonacci levels using a daily chart and looking back from six months to one year. You can also use Fibonacci on intraday charts too. Step 2 Identify significant price points.

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Locate a major high and a major low on the chart. These points are typically extreme values within a certain period like the highest and lowest prices in a recent trend. Determine the trend. Decide if the trend you are analyzing is bullish or bearish. For a bullish trend, you draw the Fibonacci retracement tool from the bottom or or low to the top or high.

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For a bearish trend it's the opposite from the top or high to the bottom or low. Step 4 Draw the Fibonacci lines Click on the major low and drag the tool to the major high for a bullish trend. If it's a bearish trend, start at the major high and drag to the major low. When you release the mouse button, the Fibonacci retracement levels will appear on the chart. Step 5 interpreting the retracement levels the tool will display horizontal lines at the key Fibonacci levels of 23.6%, 38.2%, 50%, 61.8% and sometimes 100%.

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These percentages represent how much of the prior move the price has retraced trading using the Fibonacci levels. The lines can indicate potential support or resistance levels. Traders often look for price action at these levels to make trading decisions, such as entering a trade when the price bounces off a Fibonacci level setting, stop loss orders near a Fibonacci level, or taking profits or closing a position when the price reaches a Fibonacci level. Next, we will look at some practical examples. We will cover the following examples.

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Fibonacci in a bullish how to use the different levels Fibonacci in a bearish trend, Fibonacci in conjunction with other indicators and Fibonacci extensions as tools for take profit targets let's start. The first example is Fibonacci in a bullish trend. Here we look at the Microsoft stock. We need to look at the market structure and identify pivot points to draw our Fibonacci level. Here we can see higher highs and higher lows.

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We can see a medium term uptrend and we are looking for a potential long entry. We can draw the Fibonacci levels here by connecting the swing low to the swing high. The 38.2% level can be the first signal of entry. The 50% can provide a stronger signal and the 61.8% can help us identify a more relevant level for a strong retracement. Here we can see how the stock continues its uptrend move.

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Now let's look at how we use the different levels. The 38.2% retracement level is considered the first potential support or resistance level during a retracement. If prices retract to this level and then resume the original trend, it signifies a relatively weaker retracement and a stronger ongoing trend. In this example we see a stock in a strong upward Trend and the 38.2 can be a very good level of entry. Stop loss in this case can be placed at the 50 or 61.8 level.

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This can help with our risk management. The 50% level is watched as a psychological support or resistance level. It's common for prices to retrace about half of their previous move before continuing in the original direction. This level often acts as a deciding point for the strength of the current trend. Many traders use this level as a potential entry Point.

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The 61.8% level is considered the most significant in Fibonacci retracement analysis. If the price retraces to this level and then resumes its previous trend, it indicates a stronger retracement but still maintains the validity of the ongoing trend. This level is closely watched as a last major stand for the trend continuation. A break below this level could be a sign of a potential reversal. The 61.8% level can be used as a potential entry if you are looking to go long a stock or as a potential stop loss if you are already in the trade.

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It's important to understand that when setting stop loss orders using Fibonacci levels, we typically don't rely on the exact numerical value. Instead, we focus on an area or a zone around that level. This approach aligns with the principles we explored in the support and resistance lesson. The rationale is to provide a trade with enough room to evolve and avoid premature stopouts. While price often responds to these Fibonacci levels, it may not do so at the precise value.

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Therefore, allowing some flexibility around these levels can lead to more effective trade management. Now we can do the same in a bearish trend and use Fibonacci to signal a potential short position. To do so, we need to look at the market structure and identify pivot points to draw our Fibonacci level. In this case, we look at this stock, we can see a medium term downtrend and we are looking for a potential short entry. We can draw the Fibonacci levels here by connecting the swing high to the swing low.

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We can then use the different levels in the same way. As per the uptrend. The 38.2% can be the first signal of entry. The 50% can provide a stronger signal and the 61.8% can help us identify a more relevant level for a strong retracement. Here we can see how the stock continues its downtrend move.

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The 61.8% level can also be a sign of a trend reversal if the price breaks above and can be used for our stops if we are in a short trade on the asset. Fibonacci levels are based on statistical probabilities. They are a great indicator to spot entry and exit levels. The best way to use Fibonacci retracements is in conjunction with other indicators. The first example is combining Fibonacci with support and resistance levels.

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As we can see in this chart, we notice how some Fibonacci retracement levels align closely with key support and resistance areas. These confluence points are where you should be extra vigilant for trading opportunities. Now let's add a moving average. For this example, we'll use a 200 day moving average. The moving average helps us gage the trend's direction.

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A price above the moving average indicates a bullish trend and below signals a bearish trend. In this chart, the price is retracing in a bullish trend as it approaches a significant Fibonacci level. It also nears the 200 day moving average. This dual support zone increases the likelihood of an efficient entry point. We can set out stoploss just below the confluence zone or near another key level like in this case.

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Let's do a last example. Combining Fibonacci with rsi. Here we see a stock in a bullish trend experiencing a strong retracement around the 61.8% level. We can also see that the RSI is below 30 in oversold condition. This confirmation can be a good sign for a potential long.

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In this case, this could have given us a nice upward move for our trade. Combining Fibonacci retracement levels, support and resistance and moving averages increases the probability of identifying significant market turning points. But it's not a guarantee. The last example is on how to use Fibonacci as a take profit target for our trading. For this we will use an additional tool available on trading platforms, the Fibonacci extensions.

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Fibonacci extensions are based on the same mathematical principles as Fibonacci retracements. While retracements focus on the pullback of a price move, extensions are used to predict where a price move might go after it breaks through the high or low of a previous trend. To start using Fibonacci extensions, first identify a significant high and low in a recent trend. This is your reference range. For an uptrend, select the low and then the high.

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For a downtrend, do the reverse. We can find the Fibonacci extensions here in trading view. The tool will automatically plot the key Fibonacci extension levels. Such as 138.2%, 150% and 161.8%. We can change the levels we want to see here in the settings by double clicking in an uptrend, Fibonacci extensions can help identify where the price might head next after breaking past the previous high.

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These levels become potential areas of resistance where the price might stall or reverse. Let's look at an example of an uptrend. We first use our Fibonacci retracements to define our entry point. We can then use extensions to define our profit target here. After breaking past the previous high, the price approaches the 61.8% extension level.

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Traders might consider this a potential target for taking profits or a point to evaluate the strength of the trend in downtrends. Extensions are used similarly, but as potential support levels. These levels can indicate where the price might find a floor after breaking below the previous low. As we can see in this example, Fibonacci extensions can be a very efficient tool to identify potential targets. This concludes our lesson on Fibonacci retracements and extensions.

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We can now start looking at risk management and other trading examples.