Fibonacci Retracement is one of the most essential tools for traders which they use with support and resistance and other tools in their technical analysis. In simple words, Fibonacci retracement levels are horizontal lines that indicate where support and resistance are likely to occur. We have all heard of Fibonacci numbers, which are a series of numbers in which each number ( Fibonacci number ) is the sum of the two preceding numbers.
In a Fibonacci retracement, traders take two extreme points (usually a peak and a trough) on a trading chart and divide the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100%. The first question arises:
How Fibonacci Rations work?
Based on the above definition, the fibonacci sequence goes as: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. If we pay attention to the numbers closely, each number is approximately 1.618 times greater than the preceding number. One of the key Fibonacci ratios is 61.8%. It is found by dividing one number in the series by the number that follows it.
89/144 = 0.618
144/233 = 0.618
377/610 = 0.618
The 38.2% ratio is discovered by dividing a number in the series by the number located two spots to the right.
13/34 = 0.382
21/55 = 0.382
34/89 = 0.382
The 23.6% ratio is found by dividing one number in the series by the number that is three places to the right.
13/55 = 0.236
21/89 = 0.236
34/144 = 0.236
As mentioned above, Fibonacci Retracement is tracing horizontal lines at different support and resistance levels. The horizontal line at the highest point is considered to be at 100%. Traders draw horizontal lines at other Fibonacci ratios. It shows how much of a prior move the price has retraced and the extent to which the direction of the previous trend is likely to continue. However, the price of the asset usually retraces to one of the ratios listed above before that happens.
Firstly, identify two key price points on the target chart: highs and lows of the chosen timeframe. Draw a line between these levels to get 0% and 100% points. There are two potential locations:
- Uptrend. The low represents 100% here while the high is 0%. Four levels between these points show key potential support levels which will be likely tested during the market retracement (that’s why we call them the Fib retracements).
- Downtrend. Respectively, the low point of the chosen downtrend is 0% and the high point is 100%. In this case, the Fibonacci numbers represent resistance levels that may be tested during the potential uptrend.
Let’s say you see that the price starts falling during the uptrend. Then, you can draw a line, identify levels, and set targets for two close points: buy 78.6%, sell 61.8%. Also, you will know that it’s better to avoid trading between core levels.
Fibonacci levels are very efficient at predicting a bounce off a big red candle, upon completion of a quick rally. These quick trades can generate a 20–40% profit if timed properly. This takes into consideration that once a rally has been quickly dumped, it will typically bounce back at a Fibonacci level near or around 0.618 or 0.786, before continuing to reach new lows. This tool can help you to identify favorable support and resistance levels, set target prices, and place stop-loss orders.
Needless to say that Fibonacci Retracement isn’t the one and only TA tool you should use. It works best when you combine it with other indicators: RSI, MACD, moving averages, candlesticks. Moreover, it’s essential to use FA skills, too. Solely, the Fibonacci levels can’t help with your strategy but they can act as a great confirmation tool.