Fibonacci Retracement - The Complete Guide

Introduction

Fibonacci retracement levels are based on Fibonacci numbers and Fibonacci ratios, which find their ways in all walks of life. There are various trading tools based on Fibonacci ratios but Fibonacci retracements lead the way and are very commonly used in the technical analysis.

What are retracement levels in trading?

What goes up, comes down and what goes down, comes up. Even during very strong trends, prices go for temporary corrections and consolidate quite frequently. The retracement levels derived from Fibonacci ratios indicate the levels to which the price action may consolidate before continuing in the direction of the ongoing trend

Graphical illustration of retracement levels - 1

Fibonacci retracement- example 1

Graphical illustration of retracement levels - 2

Fibonacci retracement - Example 2

Before we discuss about Fibonacci retracements, let's see what are Fibonacci sequence of numbers and how are these applied in the technical analysis

Introduction To  Fibonacci Sequence

Fibonacci sequence is a series of numbers in which each number is the sum of the previous two numbers. The first two numbers of Fibonacci series are 0 and 1 or the typical binary numbers. Let's start with these two numbers and check how the series develops:

  • First two numbers: 0, 1.
  • Third number = 0+1 = 1.
  • The extended series = 0, 1, 1.
  • Fourth number = 1 + 1 = 2.
  • The extended series = 0, 1, 1, 2.
  • Fifth number = 1 + 2 = 3.
  • The extended series = 0, 1, 1, 2, 3.

If we continue adding the latest two number to get the next number, we get a series of numbers as follows:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, and so on.

The above series is nothing but Fibonacci series of numbers or Fibonacci sequence.

Fibonacci Ratios

The importance of Fibonacci sequence lies in Fibonacci ratios. Fibonacci ratio relates to the famous Golden ratio which is quite important in mathematics, art & architecture and even in nature.

What is the Golden Ratio?

Golden ratio is derived by two numbers when the ratio of those two numbers is same as the ratio of the sum of those two numbers to the larger number. This is explained as follows:

  1. Let's assume we have two numbers "X" and "Y" where X is greater than Y i.e. X > Y.
  2. The sum of two numbers = X+Y.
  3. The ratio of the two numbers = X/Y.
  4. The ratio of the sum of these two numbers with the greater of these two = (X+Y)/X
  5. With the above the "X" and "Y" would have a "Golden Ratio" if (X/Y) = (X+Y)/X

If we analyze Fibonacci sequence we will find that the consecutive numbers in the series are all with the Golden ratio. Let's pick up two numbers e.g. 233, say X and 144, say Y.

  1. Now X/Y = 1.618
  2. And (X+Y)/X = (233+144)/233 = 377/233 = 1.618.
  3. Hence (X/Y) = (X+Y)/X and that makes it a "Golden ratio".

Constant ratios

Now  let's have a look on the Fibonacci sequence once again:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, and so on.

Now let's pick up any four consecutive numbers after 8 and check the ratios. Let's say the first set we pick up is 8, 13, 21 and 34. The ratios for these are as follows:

  1. 8/34 = 0.236
  2. 13/34 = 0.382
  3. 21/34 = 0.618

Let's pick up another set of four numbers, let's say 55, 89, 144 and 233. Now the ratios for these numbers are as follows:

  1. 55/233 = 0.236 (23.6%)
  2. 89/233 = 0.382 (38.2%)
  3. 144/233 = 0.618 (61.8%)

This is the essence of Fibonacci numbers that the ratios will remain constant. Please note that the numbers at the beginning of the series i.e. 2, 3 and 5 etc only result in the approximate ratios but not the exact. The exact ratio comes into the picture as mentioned above and then the ratios remain constant as we move ahead with the numbers. 

These Fibonacci ratios can be found in nature, science, architecture, music, art. A few examples of these ratios can be found in pine cones, sunflowers, pineapples, palm trees, spider webs, snail shells, DNA molecules and millions of other things in the universe.

Fibonacci ratios as retracement levels in trading

The Fibonacci ratios as percentage are what Fibonacci retracements in technical analysis are all about. The 0.236 is 23.6% retracement, 0.382 is 38.2% retracement and 0.618 is 61.8% retracement. The most common retracement levels are as follows:

  1. 23.6%
  2. 38.2%
  3. 61.8%

Apart from the main retracement levels as mentioned above the other retracement levels which are also noted are as follows:

  1. 50% retracement level which is derived by dividing the second and third number of the Fibonacci series i.e. 1 by the fourth number i.e. 2.
  2. 76.4% retracement which is derived by subtracting 23.6% retracement  from 100%.

In technical analysis, Fibonacci retracement Levels are used as support and resistance levels. During an uptrend when the price consolidates downwards then these retracement levels become support levels. Similarly during a downtrend when the price retraces for correction or consolidation then these levels become resistance levels. The most commonly used retracement levels are 38.2%, 50% and 61.8%.

Use in Technical Analysis

The common occurrence of Fibonacci ratios in the life made technical analysts explore the possibilities of these ratios to appear in the rapidly changing prices of commodities, stocks and then Forex also. We can always argue about the relevancy of this and debate about the logic. If we do that then we will end up winning as we will fail to find any logic behind it. But then nothing is logical speculative markets. Markets move because of speculations and traders need some grounds or reasons for those speculations. If a lot of volumes get traded because of the beliefs on any technical analysis indicator then those volumes become the driving force for the momentum in the direction of those trade positions. In simple way, if lots of people are buying then the prices would go high and if large volumes are being sold the prices would fall further.

When to use?

The first indication of a consolidation towards the Fibonacci retracement levels is when during a trend there is a slow-down in the momentum and the price-action starts going in the sideways. This situation may be an opportunity to enter the market to target the retracement levels. 

When you come across such situation then you may like to check for a trading signal generated by some other indicator e.g. MACD or moving average crossover as a confirmation for the entry.

Please refer the following charts:

Illustration on Forex chart:

Fibonacci technical analysis- Example 3

In the Forex chart 3 there is was a strong upward move from point "A" to point" B". The price action found resistance at point B and fell. Just see how perfectly there was a drop to exactly 38.2% level before moving up again?

Let's check the price movement in figures:

  • A = 1.4458
  • B = 1.5900

Hence total upward move was B – A = approx 1442 Pips

The price dropped to 1.5359 from point "B" i.e. 1.5900 - 1.5339 = 551 pips i.e. (551/1442)*100 = 38.21%

Please do not expect the retracements to be exact and it is always better to put the profit target a few pips before the retracement levels.

Trade Entry and Exit

► Against the market trend

When a reversal or correction starts taking place, we can enter the market in the direction opposite to the ongoing trend. The profit target would be the retracement levels indicated by Fibonacci tool. profit taking targets.

► Positions along the trend

When there is a continuous trend, wait till a reversal in the movement starts taking place. In this case we can wait till the price hits the Fibonacci retracement levels and enter the market in the direction of the ongoing trend. In other words during an uptrend we enter a trade near the support levels indicated by Fibonacci and during a downtrend we take a trade position near the resistance levels indicated by Fibonacci retracements.

When the trends are very strong the consolidation may be limited and in such cases we may like to enter into a trade near 38.2% retracement level, on the other hand during weaker trends the consolidation may be more and such conditions may call us to enter a trade near 61.8% retracement level.

Illustration of consolidation during trend:

Fibonacci - trading example 4

In the above Forex chart, the upward move started from point A. The prices rose to point B and then there was a pullback. Please see the small green candle encircled by the yellow circle. This green candle shows that during this period the price opened between the 38.2% and  50.0% retracement levels and closed also between these two levels. However, during this period the price action went down up to point X which was 50.0% retracement level and went up again to point Y. During the next period, represented by the bigger red candle, it went further down closer to 61.8% retracement level. During the next period which is represented by the bigger green candle, the prices went and crossed 50.0% level and then moved up. It subsequently moved higher towards point “C”.

The above two examples are for retracement to Fibonacci levels during an uptrend. The similar pull back can be seen during downtrends:

Unique feature of Fibonacci retracements 

We find Fibonacci retracements working as we expect, time and again. What makes them perform so well? Every other technical analysis indicator has dependency on the time-frame. For example one trader may be using daily chart and another a 4-hourly chart. The signals by any other indicators would be different on these charts of different time frames. The uniqueness of Fibonacci retracement levels lie here. If we are considering the overall movement during a trend then it is independent of the time-frame.

Fibonacci retracements depend upon the peaks and bottoms of the price-action and whatever is the time-frame of the chart, these highs and lows are absolute and independent of the time-frame.

Fibonacci  retracement is the most commonly used tools in technical analysis but you may also like to check other Fibonacci tools like Fibonacci Arcs, Fibonacci Fans and Fibonacci Time Zones.

You may also use Fibonacci Pivot Point Calculator to calculate Fib. pivot points and support and resistance levels.

Check our daily updated Fibonacci support and resistance levels in Forex analysis page.

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