What is Fibonacci Retracement and how to use it?
What is Fibonacci retracement and how to use it? Read this article and learn how to trade with retracement lines. First, if you are not sure what Fibonacci number and ratio is, check this short article, where you can get some answers.
How to draw retracement levels? It is easy like ABC
Should price touch the retracement levels?
What retracements levels should I use?
I have my retracements, when should I open trade?
Opening the trade: option 1
Opening the trade: option 2
Opening the trade: option 3
Where to put stops?
Before we learn more about Fibonacci retracements, let’s talk about price behavior for a minute. Price can be trending up, down or move sideways. Of course we are looking for investing opportunities in an up and downtrend, trying to avoid investing where there is no clear direction.
Let’s assume, that we have identified an uptrend. Does price go up all the time? No, price makes higher highs and higher lows. That is a sign for us that we have an uptrend. It may looks similar to example below:
Same is with downtrend. Price makes lower highs and lower lows. Again, look at chart below and you should understand it right away:
This behavior gives us an important information – we are able to identify the current trend. When there is a pattern of those higher highs or lower lows we can draw Fibonacci retracement lines. You can read how to draw them right in a minute. [go to top menu]
In most cases price moves at zig-zag shapes. Some call it waves, and there is a whole science called Elliott wave theory. But for us it is important to know the nature of those moves. First, we need to identify a swing move, so a move from point A to point B. After the main swing there should be a correction to the point C. When we see the move from point A to B, we wait for retracement (correction) to the point C. Point C is located between points A and B. On chart for trend up it may look like this:
It is not always so easy to identify points ABC, but it’s get easier with time and experience.
When we are sure, that we have found move ABC, we can draw a Fibonacci retracement lines with tool from our charting software. We draw them from low to high of the swing, so from point A to point B.
If you are using candle charts, you should draw from the low of the shadow (or peak) of candle to the high of candle. Please, notice how much more accurate results you can get, when you apply retracement levels to candle chart. Compare it with results from above on line chart.
How to know if you have chosen the right top and bottom? It is a little bit like an art and comes with time. Sometimes, when you have two bottoms nearby even if you selected the wrong one, it is not going to change retracement levels so much. Just practice on price history. [go to top menu]
This is always a problem for new investors. They think that retracement to point C is only valid when price touches down this level. They are wrong. Fibonacci retracements are great tool, but there is no 100% efficacy. Sometimes price close only near retracement level and it can be still valid move. Just look at example below:
In a downtrend, there was a correction up. Price tried to move up to 50% retracement level but failed to do that. In a result both candles closed below 38% level. Still, it is a valid correction to point C, and then price moves back to the downtrend. Just pay attention to this. On many times price will almost exactly touch your retracement level, which is great. Be aware that sometimes price close near Fibonacci level, and it is still ok to trade in this situation. [go to top menu]
It is very confusing in the beginning, because there are many Fibonacci retracement levels. Some people use only specific ones and others like to draw all retracements. Try to use standard levels. Over time, when you gain more experience, you will decide which are the most important in your trading
So which levels should you use?
23.6%, 38.2%, 50%, 61.8%, 78%.
Why there is a 50%? It is not a Fibonacci retracement, but this is an important level (half a way up or down), so traders like to keep this retracement level together with other proper levels.
Stick to these levels, and it should be enough to trade well when it comes to price correction. [go to top menu]
That is the biggest challenge after drawing the right retracements levels. What do you need is a confirmation, signal that this is the one retracement from which price will be back moving with main trend. I write more about that in my ebook.
For now let’s just focus on your options. After drawing retracement levels, you should decide when you want to open your position. You have three options to choose from, but before further explanation, check the chart below (I stick to the line chart, but in your real trading try to use candlestick chart):
We have confirmed that main trend is strong and is up. After swing move from A to B, there was strong correction, so we have drawn retracement levels. We are waiting to take a long position, because the main trend is up.
Now we have three possibilities of doing that. [go to top menu]
You are willing to take bigger risk in turn for possible bigger return. When price (almost) reaches 61.8% retracement, you go long at this level or just a little bit above it. This level is very popular among traders, so very often at least for a moment price stops here and bounce back.
You can take the same action at 50% or 38.2% if you think that correction ends there and this is your point C.
Remember, this may not be the bounce to new highs. If you are right, possible profits can be very big, but the risk of failure is also possible. [go to top menu]
Second option is when you wait and watch how price reacts with retracement levels. If you see, that 61.8% is probably the one retracement from which bounce back may occur, you are ready to take a long position. But unlike in the first case, you are waiting for another confirmation. It could be many things like confirmation from oscillator or moving averages – simply something that is in your trading plan. When there is a confirmation signal, you go long. Of course confirmation signals are not always 100% correct, but in that case you have less chances of failure. In this example, trader decided that close of price above resistance line will be a good singal to enter a trade .
As I have mentioned, you have to decide and test by yourself, what signal works best for you. [go to top menu]
In the third case you are waiting until the price will break above recent high (the one you have used to draw your retracement levels, so the point B). You have the best chances that the move will continue. This way to trade is the safest one, but your possible profit is the smallest from three options.
Personally I trade this scenario very often. I simply wait for break above point B and go long at this point.
Which way is the best for you? It is your decision. It depends strongly from person skills and psychically strengths. How much risk are you willing to take? Do you have good and working confirmation signals? You should try all three ways and decide which one you like the most and make most money with.
See, you are not buying at the top anymore. Now you have a knowledge and you wait for correction to buy for a better (lower) price. Of course your aim is not to catch the bottom because it is very hard to do, but if you buy after correction ends, you are ahead of many others investors. [go to top menu]
Fibonacci retracements are great when it comes to placing stop losses. Let’s assume that we have a long position opened after correction to point C. Where should you place stop loss order? I like to put it below point A, so below the place where swing move started. If price move down back below point A, there is probably something wrong with trend strength.
I marked below 3 possible places you can place your stop loss order:
It all depends from how aggressive you want to trade. Sometimes I place stop loss just below 78% retracement. If you want to place tide stop loss, you place it below retracement where you think point C is.
The great thing is that over time you will understand more the behavior of the price and be able to place stop losses in better places. [go to top menu]
You need time and practice to master trading with retracement levels. This is one of best technical analysis tools available for traders and there are many reasons for that. The most important reason is you can enter your trade at better price and book more profit.
You have to remember that you will not be always successful and right. Just try to trade when trend is strong enough. Remember about your money management and practice a lot! [go to top menu]