There are many tools available to forex traders, but the Fibonacci retracement tool is a unique tool and one of the oldest tools available to traders.
Unlike the moving averages that lag price, the Fibonacci retracement levels lead the price, which means it shows what might happen in the market before the thing happens.
Interestingly, the tool is available in every charting platform.
The tool is very useful for trading a trending market.
Traders use the Fibonacci retracement levels to find areas where there could be high-probability trade setups because those levels suggest potential places where a pullback can reverse and head back in the trending direction.
In this post, we will discuss what the Fibonacci retracement levels really mean, how to attach the tool, how to use it in trading, and the common mistakes to avoid when using the tool.
But before then, we’ll explore the origin of the Fibonacci levels and the relevance of the golden ratio.
Origin of the Fibonacci retracement
We will discuss this under the following :
- Fibonacci sequence
- Fibonacci ratios
The Fibonacci sequence
The Fibonacci retracement levels are derived from the various Fibonacci ratios, which are, in turn, derived from the Fibonacci sequence of numbers.
Discovered by an Italian mathematician, Leonardo de Pisa (nicknamed Fibonacci), the Fibonacci number sequence is a numerical series in which each number in the series — with the exception 0 and 1 — is the sum of the two numbers before it.
So, the Fibonacci number sequence looks like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, and continues like that till infinity.
Taking a closer look at the numbers, one thing you will notice is that from 21 and above, each number is about 161.8% of the number immediately before it.
To put it in another way, each number is 61.8% of the number immediately after it. For instance, if you divide 34 by 55, you will get 0.618, meaning that 34 is 61.8% of 55.
Going the other way round, if you divide 55 by 34, you will get 1.618, which is widely regarded as the golden ratio because of its occurrence in several aspects of nature.
Leonardo Fibonacci discovered all this during his youthful age in the Mediterranean. Born in the year 1170 in the Italian city of Pisa, the young mathematician made several eastern trips with his father and even lived with him in Bejaia — a Mediterranean port in northern Algeria.
It was at this time that he studied mathematics and learned the Hindu-Arabic numeral system.
When he eventually returned to Italy in 1202, Leonardo documented his findings in what became a famous mathematics compendium — ‘Liber Abaci’.
This work popularized the Hindu-Arabic numeral system in Europe and the rest of the western world.
The Golden ratio and other Fibonacci ratios
As we stated earlier, aside from the first few numbers, dividing a number in a number in the sequence with the number immediately before or after it gives a fairly consistent ratio — 1.618 or 0.618, as the case may be.
The value, 1.618, is widely known as Phi or the golden ratio since we encounter it in different things in life, including the financial markets.
In the financial trading world, the 0.618 ratio or 61.8% gives rise to the 61.8% Fibonacci retracement level, while the 1.618 ratio or 161.8% gives rise to the 161.8% extension or expansion level.
Aside from the golden ratio and its inverse, other ratios can be derived from the numbers in the Fibonacci sequence.
For instance, dividing a number by the number two places to the right — say, 89 divided by 233 — would give 0.382 (38.2%), which is one of the Fibonacci retracement levels. The inverse of 0.382 is 2.618 or 261.8% — another expansion or extension level.
Again, if you divide a number in the sequence by a number three places after it — say, 34 divided by 144 — you will get the ratio 0.236 (23.6%), which is one of the Fibonacci retracement levels too.
While some say that the 50% and 100% levels are not technically derivatives of the Fibonacci ratios, but 1, 1, and 2 are members of the sequence — dividing 1 by 2 gives 50%, while dividing 1 by 1 gives 100%.
There may be other ratios from the Fibonacci number sequence, but when it comes to forex trading, Fibonacci ratios like 0.236, 0.382, 0.618, 1.618, and 2.618 are the significant ones.
But away from the technical analysis of the financial markets, the golden ratio, or its inverse, is quite prevalent in different aspects of our natural world and human arts.
For example, the ratio has been observed in the spiral galaxies of outer space, tree branches, sunflowers, rose petals, human faces, Leonardo da Vinci's Mona Lisa, the Parthenon, and the ancient Greek vases.
However, one of the famous examples of the ratio in nature is seen in the nautilus shell, which spirals at about the same level as the percentages from the golden ratio and its inverse.
The ratio may also be used to predict human behaviors and spending habits, which is why it works in the financial markets.
What do the Fibonacci retracement levels mean?
A trending market moves in waves — impulse waves and corrective waves or pullbacks. The impulse waves move in the direction of the trend, while the corrective waves move in the opposite direction.
The Fibonacci retracement levels show how much of the preceding impulse wave a pullback can retrace to before reversing to head back in the trending direction — starting a new impulse wave.
They indicate the percentage of the impulse wave a pullback might end, which means that a pullback is measured as a percentage of the impulse wave before it.
Thus, a 61.8% retracement level means 61.8% of the preceding impulse wave, and if a pullback reverses at that level, it means the pullback (retracement) was only 61.8% of the preceding impulse wave.
Since price reversal areas are considered support or resistance levels, the Fibonacci retracement levels, in essence, indicate potential support or resistance areas.
Interestingly, the tool highlights these levels even before the price reaches those levels. The common retracement levels are 23.6 %, 38.2%, 50%, 61.8%, and 78.6%.
If the market is trending up, then, pullbacks move downwards, so the retracement levels will serve as possible support levels.
The opposite is the case in a market that is in a downtrend — pullbacks move upwards, so the retracement levels will function as potential resistance levels.
Thus, they provide unique areas to look for trade setups.
It is believed that since traders already know about these levels beforehand, they tend to work like self-fulfilled prophecies.
That is, traders place a lot of orders around those levels in anticipation that the pullback will reverse, and it’s those huge orders that cause the price to reverse at those levels.
But whatever the case, Fibonacci retracement levels can help you spot where to look for your trade signal.
In addition to the retracement levels, which indicate potential pullback reversal levels, the Fibonacci retracement tool can be set to show levels that lie in the opposite direction beyond the high/low of the price swing it’s attached to.
These other levels are called the extension levels and can indicate potential impulse wave reversal levels.
That means, in an uptrend, the extension levels can act as potential resistance areas where an impulse wave may reverse and begin a new pullback.
Hence, these levels may indicate possible profit targets for someone riding up the impulse wave.
In a downtrend, on the other hand, the extension levels can act as potential support levels where traders can place their profit targets for short positions.
How to attach the Fibonacci retracement tool to your chart
It’s important to learn how to attach the Fibonacci retracement tools properly on your chart because that determines how well you can use the tool to find potential price reversal levels.
The tool may look different in different charting platforms, but you attach it to your chart the same way, irrespective of the platform you’re using.
If you are not used to your trading platform, you will first need to go through it to know where the tool is located and how it looks.
You can also check the levels preset in the tool to know if you can add more, especially if you want to see the extension levels since they are not always pre-set in the tool.
After that, you need to study the direction of the trend you want to trade and identify the impulse waves and pullbacks.
See the sample chart below; the market is in an uptrend. Observe the impulse (green arrow) and pullback waves (orange arrows) marked.
You aim to attach the tool to the latest impulse wave when a pullback has started so that you can anticipate where the pullback might reverse.
Attach the retracement tool from the beginning of the impulse wave to its end.
Hence, in an uptrend, you attach it from the swing low to the swing high since the waves move upwards.
This is what you do: Select the retracement tool, place your cursor at the lowest point of the latest impulse wave, and drag it up to the highest point in the wave. Take a look at the chart below.
The various levels will appear, from up to down, in this order: 23.6%, 38.2%, 50%, 61.8%, and 78. 6% — as you can see in the chart above. Notice that the pullback is currently at the 61.8% level.In a downtrend, attach the retracement tool from the swing high to the swing low, because the impulse waves are moving downwards.
After selecting the tool, place your cursor at the highest point in the latest impulse wave and drag it down to the lowest point in the wave. The various retracement levels
will appear from down upwards — 23.6%, 38.2%, 50%, 61.8%, and 78. 6%, in that order. See the chart below. Notice that the pullback ended at the 50% level.
Using the Fibonacci retracement tool in your trading
The best time to use the Fibonacci retracement tools in your trading is when the market is strongly trending in one direction — up or down — making clear impulse waves and pullbacks.
There are many ways traders use the Fibonacci retracement tool in their trading, but these are the common ones:
Pullback reversal strategy
With this strategy, a trader tries to enter the market at the end of a price pullback so as to ride the next impulse wave and get out before the next pullback begins.
To play this strategy, you must find ways of knowing when a pullback is losing momentum and identify the level where it might end for a new impulse wave to begin.
Many traders approach this strategy differently, and there are several indicators one can use to estimate when a price swing has exhausted its move.
But to predict the possible price reversal levels, one of the most popular tools to use is the Fibonacci retracement levels and their extension counterparts.
The retracement levels
The retracement levels can serve as potential resistance or support levels, depending on the direction of the trend, and can offer great levels for your trade entry or stop loss orders.
If the market is trending up, the retracement levels serve as potential support levels. Thus, when a pullback reaches one of the important Fibonacci retracement levels —38.2%, 50%, or 61.8% — you should watch out for whatever defines your bullish reversal signal.
Your bullish reversal signal can be a bullish candlestick pattern or any technical indicator signal.
In the GBP USD chart below, the price found support at the 50% level and 61.8% Notice the inside bar pattern that formed at the end of the pullback, which could be a signal to go long.
Also, note the hidden divergence (blue line) and the oversold signal in the stochastic indicator — another possible signal to go long.
If you see your setup at any of the Fibonacci retracement levels, you can go long and place your stop loss below the next higher retracement (lower) level, next two higher levels, or the 100% level — which represent the previous swing low. See the chart below.
In a market that is trending down, the retracement levels serve as potential resistance levels where a price rally can reverse.
When the price pulls back to 38.2%, 50%, 61.8%, or even 78.6%, look for your bearish reversal trade setups, which could be a price action pattern or an indicator signal.
The GBP CHF below shows that a pin bar pattern occurred at the 61.8% Fibonacci retracement level and the price declined further.
When you have a signal at any of the levels, you can go short and place your stop loss above the next higher retracement level, next two higher levels, or even the 100% level — which represents the previous swing high. See the chart below.
The extension levels
As the name implies, the extension levels are an extension of the retracement levels beyond the price swing high/low to project where the next impulse wave might end.
Depending on the direction of the trend, the extension levels can serve as potential resistance or support levels and may provide great levels for your profit targets.
In an uptrend, the extension levels can serve as resistance levels, so you can place your profit target just below any relevant extension level — as you can see in the GBP USD chart below.
For a down-trending market, the extension levels can become support levels, so you can place your take profit order just above any of the levels.
It’s even possible to place more than one profit target, with each near a different extension level, if you want to exit your trade in batches. Take a look at the chart below.
Gartley chart patterns
These are harmonic chart patterns that are based on the Fibonacci ratios and percentages.
Just like other harmonic patterns, specific Fibonacci levels must be met for a formation to qualify as a valid Gartley pattern setup.
Depending on whether it’s a bullish or bearish pattern, the Gartley pattern may look like an M or W. So, it has five points —denoted as X, A, B, C, and D — and four price swings.
Here is what a bullish (M) formation looks like. A swing up, XA, which could be any price swing in the market.
This is followed by a pullback swing, AB, which must be about 61.8% Fibonacci retracement of the XA swing.
From point B, the price reverses to point C, which must be about 38.2% retracement from point A or 88.6% of the AB swing.
Then, the price heads downwards from point C to point D, making a 127.2% extension of the BC swing or 78.6% retracement of the XA move.
The pattern is completed at point D, and a buy signal occurs with possible profit targets at point C, point A, and a final target at 161.8% increase from point A. Most times, the stop loss is placed below the point X.
Note that these Fibonacci levels need not be exact, but the closer they are, the more reliable the Gartley pattern would be.
The bearish version of the pattern is just the inverse of the bullish pattern and is shaped like W.
If the pattern is completed at the fifth point (D), it suggests a potential bearish move with several profit targets
Elliot Wave method
Elliot Wave Theory states that the market moves in waves, which include the impulse wave and the corrective waves.
The impulse wave moves in the direction of the trend, while the corrective waves are retracements of the impulse waves.
Within each wave, there is a set of waves that adhere to the same impulse/corrective wave pattern.
The impulse wave has five waves within it — three smaller impulse waves (wave1, wave 3, and wave 5) interspaced by 2 smaller corrective waves (wave 2 and wave 4).
On the other hand, the corrective wave has three smaller waves within it — wave A, wave B, and wave C.
Traders who follow this method use the Fibonacci retracement levels to predict where the corrective waves can reverse for the next impulse wave to begin.
In the GBPAUD chart below, you can see the impulse and corrective waves, with the smaller waves within each.
Notice that the corrective wave reversed at the 50% Fibonacci level.
Mistakes to avoid when trading with Fibonacci retracement levels
There are a few serious mistakes some traders make when trading the Fibonacci retracement levels. We will discuss some of them here so that you can avoid them.
Trading Fibonacci retracement levels on short timeframes
Some traders try to trade the Fibonacci levels on very short timeframes, such as the M15 and M5, but the levels work better on higher timeframes.
In fact, it’s better if you don’t go below the H4 timeframe when attaching the Fibonacci tool.
After marking the levels on a higher timeframe, you can step down to the lower timeframe to look for your trade setups when the price reaches any of the Fib levels.
Going against the main trend
Going against the trend can be very disastrous for your trading account, so try to avoid it by all means.
It is one of the reasons you should stick to higher timeframes — preferably, D1 and H4 — because it’s almost impossible to identify the direction of the main trend in a lower timeframe.
Trading only the Fibonacci retracement levels
That the price has retraced to the 50% or 61.8% Fibonacci retracement level does not mean that it would reverse and resume in the trend direction.
Those levels are only a guide for where you can look for trade setups.
Additionally, it’s even better if there is a confluence of other factors, like an established support and resistance level, trend line, or long-term moving average, coinciding with an important Fibonacci retracement level.
Using a tight stop loss
Don’t place your stop loss very close to the low/high of the pullback you are trading. It is safer to keep it beyond the 100% retracement level.
Using the Fibonacci retracement levels to trade a trending market can improve the odds of your trading outcome if you use it correctly.
However, there’s a need to combine it with other supporting factors to even increase your chances further.
Additionally, you must have clear criteria to identify a trade setup when the price reaches a significant Fibonacci level. Above all, ensure use give your trades enough room — avoid tight stop loss.