Fibonacci retracement levels are a true reflection of the market psychology.
There will be times when the market will make a pullback to correct a downtrend or uptrend before it continues.
There will also be times in the market when traders will anticipate a momentum continuation for a “zigzag”.
In all these cases, Fibonacci retracements give traders discounts for entries while Fibonacci targets give profitable opportunities for exits.
Due to this, forex traders use Fibonacci levels to determine where to place orders for market entry, taking profits, and stop loss orders.
They also help forex traders to identify and trade off support and resistance.
After the price has made a significant move, either upwards or downwards, the new support and resistance levels normally move at or near these trend lines.
This shows that Fibonacci levels are very important to you as a forex trader.
They can help you make better trading decisions and increase your chances of becoming a successful forex trader.
In this article, I will help you know why Fibonacci retracement works.
What is Fibonacci Retracement?
The Fib retracement levels are horizontal lines that show where support and resistance are likely to be formed on the price chart.
They are derived from Fibonacci numbers.
Each Fibonacci level is associated with a percentage.
The percentage shows the amount of prior move that the price has retraced.
The Fibonacci ratios include 23.6%, 38.2%, 61.8%, and 78.6%.
The 50% Fibonacci ratio is also used, but it has not been officially approved.
It is a very useful indicator since it can be drawn between any two significant price points, like the high and the low.
The indicator levels will then be drawn between those two points.
Suppose the price of a security rises by $10 and drops by $2.36.
The price will have retraced 23.6%, and this is a Fibonacci number.
So, Fibonacci numbers are found throughout nature.
Many traders believe that these numbers have relevance when it comes to financial markets like forex.
When drawing Fibonacci levels on a price chart, a trend line is first drawn between two extreme points.
A series of horizontal lines are then drawn while intersecting the trend line at the various Fibonacci levels including 0.0%, 23.6%, 38.2%, 50%, 61.8%, and 100%.
Consider the chart given below…
The above chart shows Fibonacci levels added on the price chart of a forex pair.
The trend line is the dotted line running diagonally across the chart.
Many horizontal lines have then been drawn to intersect the trend line at the various points.
The points are the various Fibonacci levels.
A closer look at these levels shows that the 100% Fibonacci level is acting like a support level.
The price level makes a bearish move and manages to hit the 100% Fibonacci level.
It then bounced off this line and reversed to begin a new bullish move.
This confirms the fact that Fibonacci levels can be used to identify areas of support on a price chart.
Also, a closer look at the 0% Fibonacci level reveals that it is acting like a resistance line.
The price action hits this level and quickly bounces off.
The price trend reversed from bullish to bearish.
This confirms the fact that Fibonacci levels can reveal the resistance areas on a price chart.
So, the percentage retracements identify the support and resistance areas.
When you apply these percentages to the difference between the high and the low price for a selected period, you will create a set of price objectives.
Depending on the current direction of the market, whether upwards or downwards, the prices will normally retrace a significant portion of the previous trend before it can resume the move in the original direction.
The countertrend moves normally fall within specific parameters, and these are normally the Fib Retracement levels.
However, you should not rely on these points exclusively because it is dangerous to assume that the price will make a retracement after hitting a particular Fibonacci level.
How to Calculate Fibonacci Retracement Levels
There are no formulas for calculating Fibonacci retracement levels.
When you need to apply these indicators on a price chart, you should first choose two points.
You can then draw a line that joins these two points.
This is the line that we called the trend line.
It shows the price trend between the two points that you have chosen.
You can then draw the other lines as percentage moves of that move.
Suppose the price moves from $10 to $15, and you use these two price points to draw the retracement indicator.
Here is how you can calculate the position of the 23.6% level…
$15 – ($5 x 0.236) = $13.82
So, the 23.6% level should be at the $13.82 price level.
Here is how to calculate the 50% Fibonacci level…
$15 – ($5 x 0.5) = $12.50
So, the 50% Fibonacci level should be drawn at the $12.50 price level.
Always remember that there is nothing to calculate when you’re dealing with Fib retracement levels.
They are just percentages of the price range that you have chosen.
However, the Fibonacci numbers themselves have a very fascinating origin.
They work based on Golden Ratio.
You create a sequence of numbers with 0 and 1.
You can then keep on adding the prior two numbers to get a number string like the one given below…
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144,…
And the String can continue indefinitely.
All Fibonacci retracement levels are obtained from this number string.
Once the sequence gets going, if you divide one number by the next number you will get 0.618, or 61.8%.
If you divide a number by the second number to its right, you will get 0.38, or 38.2%. All ratios, except the 50% depend on some mathematical calculation that involves this number string.
Remember that the 50% ratio is not an official Fibonacci number.
You can use these levels to place entry orders, determine the stop loss levels, and set profit targets.
A trader may see the price of a forex pair moving higher.
After the price has made a significant move, it retraces back to the 61.8% level.
It then begins to move up again.
Since the bounce happened at a Fibonacci level during an uptrend, the trader buys the forex pair.
To remain protected, the trader may decide to set a stop loss at the 61.8% level.
The reason is that a return below that level may be an indication that the rally has failed.
There are also other ways through which Fibonacci levels arise in technical analysis.
They are also common in Elliot Wave theory and Gartley patterns.
After the price has made a significant move upwards or downwards, these types of technical analysis find that reversals tend to occur close to particular Fibonacci levels.
The Fibonacci retracement levels are static prices and they don’t change unlike moving averages.
Since these price levels are static, traders can identify them quickly and with a lot of ease.
They make it easy for traders and investors to anticipate and react wisely once the price levels are tested.
Such levels are inflection points at which a form of price action is expected, either a break or a reversal.
Why do Fibonacci Levels Work?
As we have discussed above, Fibonacci is a mathematical concept.
The 61.8 ratio is popularly referred to as the Golden Phi or Golden Ratio.
This means that the 61.8 ratio is extra special compared to other Fibonacci levels.
Phi is an important element in forex trading.
Two quantities are said to be in golden ratio if…
The ratio of the sum of the quantities to the larger quantity is equal to the ratio of the larger quantity to the smaller one.
Mathematically, this can be written as follows…
((A+B)/A) = PHI
The PHI is equivalent to 0.618.
This explains why the 61.8 or the 61.8 Fib retracement level is very important in forex trading.
The Golden Phi is a bit more important than other numbers in forex trading.
When do Fibonacci Levels work best?
Fibonacci is derived from math and it goes well with the market psychology.
However, this does not mean that Fibonacci works well in all circumstances.
So, as a trader, you must know the best times when you should use the tool.
The Fib tool will not be useful to you no matter what the conditions.
There are particular moments of how and when forex traders must use this tool to their advantage, otherwise, it will not help them.
Using this trading tool in the wrong way or at the wrong time may result into more harm than good.
Fibonacci levels work well in trending markets or when the market is moving at a very high speed.
The Fib levels don’t work well in ranges, consolidations, corrections, and sideways movements.
The reason is that the Fib levels are mostly ignored and the price is more responsive to the different levels like tops and bottoms.
The Fib levels work very poorly in choppy markets.
However, if the forex pair is showing momentum or is trending, then this trading tool is a good asset.
In such cases, the Fib levels provide a precise indication where there are high chances of the market turning back in the direction of the trend.
The presence of momentum or a trend is very important when using this trading indicator.
But, how can you define momentum or a trend when trading forex?
It’s very simple, let me show you…
When the market is in an uptrend, the trend requires a lower high and a higher high.
If the market is in a downtrend, the trend requires a higher low and a lower low.
A momentum is just like a trend but on a smaller scale.
Instead of looking at the tops and the bottoms, your target should be to see candles with lower highs in a downtrend and higher lows in an uptrend.
Consider the following chart…
The above chart shows a time when the price action is in an uptrend.
This has been shown by the uptrend line, which is the black line running at the bottom of the price action.
This trend line is acting like a support line.
The price action hits the trend line for a number of times trying to break through it downwards.
These are sellers trying to push the price of the forex pair lower, but they are overpowered by the bulls.
So, a breakout downwards through the trend line never happened.
But, how can you determine the momentum of the price action on the above chart?
This has been shown by the green arrows running upwards on the chart.
Since the price is in an uptrend, we are considering lower highs and higher highs to determine the momentum in the price.
That is what we have used to draw the green arrows on the chart.
From these arrows, you can tell that there is momentum in the market.
Remember that the Fib levels should be used when the market is trending or when the moving at a high speed.
This means that it is a good time for you to use this indicator to determine the support and resistance levels.
You can then use them to make your trading decisions.
Consider the chart given below…
The above chart shows a time when the price action of a forex pair is in a downtrend.
The downtrend has been shown by the red line running downwards on the chart and marked as Trend.
Since the price is in a downtrend, we should consider higher lows and lower lows to measure the momentum in the price action.
The black arrows running downwards on the chart help us determine the level of momentum in the price.
The arrows clearly show that there is a slow momentum in the market.
So, the market is not choppy at the moment.
Since the Fibonacci levels should be used when the price has is trending or moving at a high speed, it is good time for you to use this indicator.
You can go ahead and add the Fibonacci levels on the chart and use them to determine the levels of support and resistance lines.
This will guide your decision making process like when to enter the market, when to exit, where to set stop loss and profit target, etc.
When to Expect which Levels
There are a considerable number of Fibonacci levels.
Most trader prefer to use 6 Fibonacci levels.
A major difference exists between taking a trade at the 23.6% Fibonacci level and taking a trade at the 88.6% Fibonacci level.
Taking a trade at the 88.6% Fib will offer you a more reward to risk potential.
However, the 23.6% Fib will give you higher chances of winning.
It is possible for you as a forex trader to roughly estimate the Fib retracement and target that will most likely be used in the market.
You must know that the price action respects different Fibonacci levels based on the presence of momentum or how the trend has developed so far.
Always remember that Fibonacci levels don’t work well when there is a strong momentum in the market.
Deep Pullback (61.8-88.6%)
The price of most forex pairs tends to make a deep pullback before a trend is established clearly.
In such cases, the price may make multiple ups and downs which severely test the top (downtrend) or bottom (uptrend) but without breaking the levels, which can make the trend invalid.
Shallow Pullback (23.6-50%)
After a trend has established itself clearly, a shallow pullback like the 23.6%, 38.2%, and the 50% half way mark may occur, and they are very typical before a continuation of the trend.
Corrections normally deep to be less impulsive like with deep pullbacks and the price seems to correct slowly and choppy.
Consider the chart given below…
The above chart shows the price action of a forex pair at different Fibonacci levels.
During the time of Deep Fib, the chart shows that the price had made a very deep retracement.
This has been shown by the lower lows that were formed in the market during that time.
A closer look at the horizontal Fibonacci lines reveals that they are widely spaced.
This is an indication that there are major price swings in the market, meaning that the market is volatile.
However, this is not the case with the price action during the formation of the Corrective Fib.
During this time, the price action was making a sideways movement, creating what is popularly known as a Range.
During this time, the price action doesn’t show a strong momentum, which is clearly shown by the small price swings.
A closer look at the horizontal Fibonacci lines reveals that they are tightly spaced, which is a signal that the market is less volatile at that time.
Also, we have the Less Deep Fib on the chart.
At this time, the price action is moderately volatile, which is clearly shown by the small price swings in the market at that time.
A closer look at the horizontal Fibonacci lines reveals that they are a bit spaced out, meaning that the market is moderately volatile.
The price can also make a pullback at a time when it’s making a sturdy and clear momentum against the trend.
In such a case, a 3 legged zigzag may allow the price to make a shallow or a deep correction.
Note that the price can still form both deep and shallow corrections.
The price can make a quick retracement, go slowly with the trend, then retrace quickly after which the trend resumes fully.
As a trader, you must be able to recognize such a situation whenever you are trading with the trend.
Otherwise, you will get stopped out and watch as the price begins to go your way.
In such a case, the zigzag may bring the price back to a deep pullback and a confluence exists between the Fibonacci target and the Fibonacci retracement.
Which Fibonacci Retracement Levels to choose?
As we stated earlier, the 61.8% level is the most popular Fibonacci level among Forex traders.
However, there are situations under which other Fibonacci levels make more sense.
Let’s discuss the circumstances under which you should consider using each Fibonacci level…
- 2% Level- This Fibonacci level should be used when the price makes a retracement to the 78.6% or the 88.6% Fibonacci level.
In such a case, the price may make a deep retracement, meaning that it has a less momentum than when it retraces to a shallower Fibonacci level.
The lack of momentum may be a warning sign that the price may not be able to hit a bigger target such as the 61.8% target.
So, it will be better for you to take profit at the 27.2% Fibonacci level.
- 8% Level – You can use this Fibonacci level in case of 23.6%, 38.2%, 50%, and the 61.8% Fibonacci levels.
- Variable Level- Use it when the price is at the beginning of a correction or turnaround.
In such scenarios, you can choose to mix Fibonacci levels.
If you have a higher time frame that shows a big trend, you can aim for the 161.8% or 261.8% level.
If you only expect the turnaround to be a correction, then it will be good for you to aim for a lower turnaround such as 27.2% or 61.8%.
- 8% Level- Use this Fibonacci level when the price is in the middle of a trend.
When you think that the price has just begun to trend relatively recently and a big trend is pushing the price on the daily chart, you can aim for a better target and more pips by taking profit at the 161.8% Fibonacci level for some bonus profit.
- 8%- Use this Fibonacci level if the price is at the end of a trend.
When a trend is about to come to an end, the price action typically runs out of energy and momentum.
The divergence also becomes very clear.
Although there are Fibonacci levels that are suitable for particular scenarios, it will be good for you to keep the levels flexible and adjust them for every situation.
This is of essence to let the winners run when it’s possible and take profits at reasonable distances when there is no possibility of a big run.
How to Trade with Fibonacci Retracement Levels
As a trader, you can use the Fibonacci targets for 2 things…
Exit at Fibonacci Levels
Fibonacci Levels give you a good opportunity to exit the trade and optimize your profits as much as you can.
Optimizing profits is good if you need to attain maximum rewards.
So, you can enter trades using the retracement levels.
The Fib retracements provide traders with opportunities to enter the market when the price reverts to a lower or higher price after experiencing a gain or decline.
After the price encounters a retracement, you can anticipate the future direction of the price and enter a trade in the same direction as the market.
This will increase your chances of becoming a successful trader.
If you expect the price of the forex pair to drop, you can short it after it reaches a retracement level, and you can use the next retracement level as the stop loss target.
If however you expect the price to move higher, you can use a Fib retracement target as the entry point once the price closes above it.
Enter counter trend trade at the Fibonacci Levels
Traders earn profits when they look for big bounces at these levels.
It’s riskier, but always remember that most traders exit their trades at these levels, creating an opportunity for a counter trend trade.
Consider the chart given below…
The above chart shows the price action of a forex pair in a bullish trend.
The bullish trend has continued for some time.
The 61.8% and the 78.6% Fibonacci levels have been added on the price chart.
These two Fibonacci levels have been added to the beginning of the uptrend.
It is true that there is a possibility of the price retracing back to these two levels.
The bullish trend attempted to enter a consolidation period.
During this consolidation period, the price action almost pulled back to the 61.8% Fibonacci level.
Due to this, these two levels can be used as potential entry points.
A closer look at the price action reveals that it maintained a bullish trend for a very long time.
Actually, the price never managed to pull back to any of the two Fibonacci levels.
The consolidation period almost hit the 61.8% Fibonacci line, but it did not manage to do so.
So, if you had entered a long position at any of the two Fibonacci levels, you would have made profit from the bullish move.
After entering a long position, you should protect your trade using a stop loss.
The reason is that you are not certain that the bullish trend will continue for long.
So, you can place the stop loss below the Fibonacci level that you have relied on to enter the market.
However, ensure that the stop loss is placed a distant enough so that it is not triggered unnecessarily by minor price consolidations that may occur in the market.
Consider the following chart…
The above chart shows how to use the Fibonacci levels to enter the market and set stop loss orders.
The entry point has been pointed to by a black arrow marked as Entry Point.
This is the time on the price chart when the price manages to break through the 61.8% Fibonacci level.
To protect the trade, you need a stop loss.
The ideal position to place the stop loss has been shown by a red horizontal line marked as Stop Loss.
In case the price makes a reversal and begins to move downwards, the stop loss will be triggered and you will exit the trade.
This will protect you from incurring a loss and protect your trading account from being wiped out.
The stop loss has also been placed a distant enough from the entry point.
This will ensure that it is not triggered in case a minor price consolidation occurs in the market.
If the stop loss is triggered when it is too early, you will exit the trade prematurely and you will miss out on making profits.
This is what you’ve learned in this article…
- Fibonacci levels are a true reflection of the psychology of the market participants.
- Traders use the Fibonacci levels to identify the levels of support and resistance on their price charts.
- The Fibonacci levels are horizontal lines that show the positions on a price chart where support and resistance are most likely to be formed.
- Each Fibonacci level is associated with a percentage.
- To add the Fibonacci levels on a price chart, a trend line is drawn between two extreme points.
- The Fibonacci levels are then drawn as horizontal lines that intersect the trend line at different price levels.
- There are many Fib retracement levels, but most traders prefer using 6 levels.
- Out of these, the 61.8% Fibonacci level is the most popular among traders.
- The 50% Fibonacci level has not been officially approved.
- There are circumstances under which you should use each Fibonacci level.
- You can use these levels to determine the entry points to enter the market as well as where to set the profit targets and the stop losses.
- After using a Fibonacci level to enter the market, you can protect your trade using a stop loss. This will protect you from incurring a loss in case the market reverses and begins to move against you.
- After entering a long position, place a stop loss some pips below the Fibonacci level.
- After entering a short position, place a stop loss some pips above the Fibonacci level.