Oct 223 min read

How, When, and Why to Use Fibonacci Retracement

Author: Stefani

The Fibonacci levels were introduced by the Italian mathematician Leonardo of Pisa, more commonly referred to as Fibonacci. He introduced his famous Fibonacci sequence to the Western world in a book called 'Liber Abaci' in 1202. Even though Fibonacci himself never applied the sequence to financial markets, later traders and analysts did make use of its ratios with 61.8% referred to as the 'golden ratio' for estimating changes in the market trend and possible reversal points. These levels are known as Fibonacci retracement levels, and they have become a basic readings tool in the technical analysis of the stock and commodity markets. In the following article we will be looking at how, when, and why to use this tool for happy trading.

What is Fibonacci Retracement?

Fibonacci retracement levels are horizontal lines that traders plot in a trading chart to determine potential levels of support and resistance in the market. These are derived from key Fibonacci percentages. The lines are connected from any two extreme points of a high to a low. Traders use the retracement level to predict areas where the price action might get stalled or change its direction. These tools form part of technical analysis but should be applied together with other indicators to drive trading decisions (RSI, Volume MACD, etc.).

Important Levels

We begin with a 23.6% bare minimum retracement level indicates strong market trends where the price barely pulls back before continuing its direction.

Next we have an important but moderate 38.2% pullback level. This level is often seen in healthy trends, providing a first level of support or resistance where prices might stabilize.

The 50% Level or Psychological midpoint is not a true Fibonacci ratio but is commonly used to gauge a halfway recovery or decline in price.

The most important level is the 61.8% level, widely known also as the golden ratio. It is a key level of support or resistance. This level suggests a significant area where market trends may resume after deeper retracements.

The 78.6% is a deep retracement level. It is considered useful in volatile markets, indicating a last chance for trends to resume before potential reversal.

Lastly, the 100% Level or full retracement level. This level marks the complete reversal to the start of the original move, negating the previous trend.

When to Use Fibonacci Retracement?

Fibonacci retracement works best when markets are trending, meaning the price is largely moving in one direction. In this regard, during an uptrend or downtrend, Fibonacci retracement assists in making an educated guess on where pullbacks may stall and the trend resumes upward or downward.

How to Use Fibonacci Retracement

As it mentioned before identifying significant price points (high-low) and direction of the trend is the most important action. In an uptrend, Fibonacci retracement is drawn from the low to the high to identify potential support levels during a pullback. In a downtrend, its drawn from the high to the low to identify potential resistance levels during a rebound.

For example, when a stock is making higher highs and higher lows in an uptrend, a retracement to a key level like 61.8% could signal a buying opportunity before the trend resumes. Similarly, during a downtrend, traders might look for price action to pull back to the 38.2% or 50% level before resuming a downward move.

When Not to Use Fibonacci Retracement

During consolidation phases of markets, that is, sideways movements or low volatility, Fibonacci retracement might give a number of false signals since price action is not following a strong trend. Additionally, Fibonacci retracement can be less effective in highly news-driven or irrational markets, where prices may overshoot or simply ignore key levels.

Conclusion

In conclusion, Fibonacci retracement is a helpful tool for identifying potential reversal levels, especially when used with other forms of analysis. Yet, it is not foolproof and always subjective to interpretation and potential misinterpretation. So traders are always encouraged to use the tool with caution, alongside other indicators.