Most traders have faced problems applying the Fibonacci retracement tool, and hence they get frustrated with far too frequent stop-outs. This arises because most of them fail to understand how to apply the tool in determining the trends and reversals in the markets.
By learning the right applications of Fibonacci retracements, one can understand the dynamics of the markets much better and improve his trading strategies.
We shall explain in this article how to deal with Fibonacci retracements, and how you should take the signals of this tool to incorporate them with your strategy so one can get better results.
What is Fibonacci Retracements?
The Fibonacci retracement tool operates on the principle and application of the Fibonacci sequence, which is a series of numbers in which each number is the sum of the two preceding ones. In trading, significant Fibonacci ratios used are 23.6%, 38.2%, 50%, 61.8%, and 100%—these ratios denote levels from which a swing in price can possibly retrace to.
The Function of Fibonacci Retracements
Fibonacci retracement really highlights the potential support or resistance levels upon which price might react during the pullback of an ongoing trend. But moreover, the tool actually helps in gauging the strength of the trend: generally, the lower the level of Fibonacci retracement causing the price to back down, the stronger the trend.
Setting Up Your Fibonacci Retracement Tool
Step 1: Determining the Swing High and Low
- It requires that you identify first a reasonable large swing high and swing low in your chart. In an uptrend, you go from the swing low to the swing high. In a downtrend, you go from the swing high to the swing low.
Step 2: Fibonacci Tool Applied
- The tools are found in the indicators/drawing tool menus on almost all trading platforms. To build the Fibonacci levels into your chart from the swing low for an uptrend or swing high for a downtrend, click and drag to the swing high for an uptrend or the swing low for a downtrend.
Fibonacci Levels, Displayed on a Price
Importance of Bounce Rates
Understanding Fibonacci retracement levels is based on the basic concept of bounce rates. If the price bubbles back down to a lower Fibonacci ratio but retreats right away, there is a strong indication that a real trend has been formed. On the other hand, bubbling back to a higher one probably means a flimsier trend.
Key Fib Levels
- 23.6% and 38.2% Retracement: Levels indicating strong trend, bounce from here would indicate the continuance of the trend.
- 50% Retracement: The level really works as some kind of a benchmark—reversal here means, to state, that trend strength has value as of medium.
- 61.8% Retracement: This would basically be a pullback to this level, showing the trend is less strong, which at times should give a warning that the trend has been reached.
- 100% Retracement: If the price fully retraces, then it mostly indicates that the trend has come to an end and a potential reversal might get started.
Working Practical Examples of Fibonacci Retracements
Example 1: Trading an Uptrend
- Identify the Swing Low and Swing High: Identify a clear swing low and swing high on this 15-minute EUR/USD chart.
- Apply the Fibonacci Tool: Create it on a swing low toward a swing high.
- Watch for a Pullback: If price pulls back to the 38.2% retracement level and then bounces higher again, it would again show that the uptrend is quite strong. This is a great example of a good place to enter a long trade.
- Targets: Reverse the tool over this pullback and trace it over the swing that outlined it, and it will kick ass in issuing possible extension targets to take profits off of.
Example 2: Bearish Reversal Warning Sign
- Identify the Swing High and Swing Low: On a 15-min USD/CHF chart, the swing high and low are so clear.
- Apply the Fibonacci Tool: Draw the tool from the Swing High to the Swing Low.
- Look at the Pullback: If the price is retracing down to the 61.8% level, that might just mean the downtrend is losing the strenuosity it had gathered. It could actually be a leading indicator for a possible trend reversal.
- Manage Your Position: If you are on the short side, then you should either tighten your stop loss or just get out of the position to avoid a potential loss.
Add Fibonacci Retracements to the Inferior Indicators
Fibonacci retracement levels are definitely powerful but on the other hand, they should not be used in isolation. Even better, they do the work in combination with other analysis tools of technical origin.
Candlestick Patterns
- Find confluence through candlestick patterns, such as engulfing candles, doji, or hammer patterns, at Fibonacci levels. These patterns give additional weight that a reversal is potentially under way.
EMAs vs. Moving Averages
- Moving averages can be used to look at the trend direction in confirmation. If the price bounces off of some Fibonacci level and crosses above a moving average, that is further confirmation of a trend continuation.
RSI and MACD
- RSIs and MACDs—modification of moving averages—can be employed to better signal confirm overbought or oversold conditions in the vicinity of Fibonacci levels. Divergences in these indicators informally tell you a reversal is likely underway.
Errors That Should Be Avoided
Human Trade Based Only on Fibonacci Levels
- Do not trade in this with Fibonacci levels alone. Combine it with some other confirmations via price action, candlestick formations, and many other indicators to decide on the call.
Reporting Trend Strength
- But the usual texts stop short at viewing to the strength of the overall trend. A deep pullback in a strong trend—back as far as a higher Fib level—can still offer continuation, not reversal, where a shallow pullback in a weak trend—back as shallow as a lower level—may look like it’s turning to a reversal.
Ignoring Market Reality
- Keep in mind the general market environment, news announcements, and economic indicators because all of these can alter potentially technical setups.
Conclusion
Trading in conjunction with these Fibonacci retracements is quite a value add-on to any trading strategy. It helps to give you an idea of possible support and resistant levels, not to say identification of how strong a trend is. As long as you understand and use the tool properly, this will increase your trading accuracy and profitability.
Key Takeaways
- Bounce Rates: Remember that smaller Fibonacci retracement levels describe more substantial trends.
- Establish Multiple Confirmations: Combine Fibonacci levels together with candlestick patterns, moving averages, and RSI and MACD for a robust trade setup.
- Avoid Common Mistakes: Don’t trade only on Fibonacci levels without considering the level’s strength of trend and market context.
- Practice and Refine: Keep on practicing with the use of Fibonacci retracement tool to develop skills in it and adjust according to various market conditions. Mastering the use of the Fibonacci retracement helps you make a decision to trade effectively based on informed reasoning.