A Fibonacci Retracement (Fib Retracement) is a popular tool used by technical analysts to find potential support and resistance levels. Fibonacci retracements are great for determining where to enter a position, place stop losses, and define profit targets.
The ratio was founded by mathematician Leonardo Pisano, nicknamed Fibonacci. Leonardo discovered a series of numbers that created ratios found to exist repeatedly in the natural environment and the universe.
The ratios arise from the following number series: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144…
This series is derived by starting with 0 followed by 1 and then adding a number and the number to it’s left to get the third number. You repeat this sequence to build the series.
After the first few numbers in the sequence if you dived a number by the next number in the sequence you get .618. For example, 34 divided by 55 equals .618.
If you measure the ratio between alternate numbers you will get .382. For example, 21 divided by 55 equals .382.
These ratios are considered to be the “golden mean”. You can search and read all about these ratios existing in nature, but for our purposes this is enough.
Why do the fibonacci ratios work when used in trading?
Could it be some magical ratio that exists in the markets? Sure…but at the end of the day it doesn’t really make a difference.
I believe that a large enough population of traders look for these retracements and extensions and use them in their trading. Thus why they work.
Fibonacci Retracement Levels
The most commonly used fibonacci retracement levels are 0.236, 0.382, 0.500, 0.618, and 0.764.
The 50% retracement level is not derived from a fibonacci ratio. However, it is commonly used and was made popular by Charles Dow, found of Dow Theory. The 50% retracement levels is the most influential level where key reversals and trend continuations occur.
Fib Retracement Levels are tend to work best after a significant move in a trending market. As price begins to retrace after a significant move these levels tend to form the areas of support.
On the chart below of Facebook, you can see we had a significant up move on the open. Price began to pull back and consolidate before moving higher.
Notice how price moved down to the 50% retracement level and then bounced continuing the strong uptrend.
Note, these retracement levels should be considered zones more so than an exact price. Like all support and resistance levels sometimes price will breakthrough the level slightly prior to the rejection.
Failed Fib Levels
Not all fibonacci setups work! Like any good trading strategy, you should include multiple other confirmations when looking for a setup.
Most traders consider a break of the .618 retracement a sign of a trend reversal. Thus why a lot of Fib traders will place there stop loss order behind the 61.8% retracement when they are trading using fib levels.
On the chart above of Facebook (FB) you can see the initial downtrend and retracement back to the 50% level and the eventual break of the 61.8% level. The market reverses and the downtrend ultimately fails.
In order to find and draw fibonacci levels you have to find the most recent swing high and low.
Uptrend Fib Lines
Begin by identifying the most recent swing low and high as seen in the chart below.
Next, find the fib retracement tool on your charting platform. You can find the retracement tool on the Think Or Swim platform by right clicking on your chart and going to drawings and selecting fibonacci retracements as seen below.
Once you’ve selected the Fib tool you will click on the swing low and drag your cursor to the swing high as seen below.
Notice on the chart below how price broke through the 23.6% retracement level and initially finds support at the 38.2% retracement level. Eventually the 38.2% level also failed and price retraced down to the 50% level finding support and resuming the rally.
Downtrend Fib Lines
Using Fib lines in a downtrend are similar to an uptrend. Begin by identifying the swing high and swing low.
After you’ve identified the swing high and low choose the fib retracement tool on your platform and click the swing high and drag your cursor to the swing low as seen above.
On this setup Facebook broke to new lows and retraced slightly to the 23.6% level. It consolidated for sometime between the lows of the day and the 23.6% level until a test of the 38.2% which was rejected and the downtrend continued.
Trading Using Fibonacci Retracements
Now that you have an understanding of Fibonacci Retracements lets take a look at how you can implement the use of fib levels into your trading.
Fib Levels for Entries
No matter your trading strategy, you can use price holding at a fib retracement level as an additional confirmation to enter a trade.
Let’s assume you use trend lines, as seen in green below, to look for potential entries and trend continuation after a rejection of the trend line.
As discussed before, the 50% level tends to be a level where strong reversals occur followed by the continuation of the overall trend. In the above example you can see Facebook rallied and price was rejected from going higher at not only the trendline but the the 50% retracement level as well.
This would have been a great entry to get in on the overall continuation of the downtrend. You can use the 50% retracement as an additional confirmation not only for trend lines but for double tops and bottoms, moving average crossovers, and much more.
Fib Levels For Stop Losses
No matter what your trading strategy, you can use fib levels to determine logical stop loss points.
Assume you were looking to short Facebook on a break of the lows. As can bee seen on the chart above you could have placed your initial stop above the initial 50% retracement level.
As the trade moves into your favor and new swing highs and lows form you can continue to draw new retracement levels. You would continue to do this until you are eventually stopped on the break of a 50% retracement. On the chart above you can see this would have happened at $119.60.
Fib Levels for Profit Targets
Whether you’re a trend or counter trend trader you can use Fib Levels to determine where to begin taking profit on a winning trade.
Let’s assume you’re countertrend strategy signaled for you to go long Facebook at $119.50 as seen in the chart below.
You can use the 23.6%, 38.2%, and 50% levels to begin to piece out of portions of your position.
You can also use these levels to manage your stops as the trade goes further in your favor. For example, after Price Target 1 was hit you could move your stop loss to break even. After Price Target 2 was hit you could have moved your stop loss below Price Target 1 where you would have been stopped out on this trade.
As mentioned earlier you can also use Fib levels if you’re a trend trader.
Let’s assume you decided to go long Facebook at 119.67 after the 50% retracement level showed signs of support. After price breaks back above the 38.2% retracement level you move your stop loss to break even. You begin to piece out of your winning trade at the 23.6% and 0% retracement levels. Potentially you leave on a third of your position for a runner.
As you have just learned, Fibonacci Retracement Levels are great for determining key areas of support and resistance. Try implementing them with your current trading strategy and let us know what you think.