How to use Fibonacci retracement in your trading strategy
Technical indicators are the first port of call for those who are new to trading. And although they only form part of a successful trading strategy, there is a good reason why they are so enticing. Not only do they give beginner traders a general idea of when to buy or sell an asset, they also apply to a wide range of different products. Today we will talk about one of these technical indicators: Fibonacci retracement levels.
Overview of Fibonacci retracements
Traders use Fibonacci retracements, among a variety of other indicators, to help work out where best to place orders to enter a market, cash out profits and make stop-loss orders. As one of the indicators that many people learn from the get-go, Fibonacci levels are often used to work out where support and resistance levels might be.
When there’s a big rise or fall in the price of an asset, these Fibonacci trend lines are a good way of seeing where new support and resistance levels could be found. Since this article is for beginner traders, we will just focus on the very basics. That means explaining who Fibonacci was, what the Fibonacci sequence is, how that relates to the Golden Ratio, and how to use Fibonacci retracement levels in your trading strategy.
To help understand this indicator better, we will use the crypto/USD charts on the eToro platform.
Who was Fibonacci?
To first understand what Fibonacci retracement is, let’s first understand a little about Fibonacci himself and something called the Fibonacci numbers.
Leonardo Fibonacci (also known as Leonard Bonacci) was a famous mathematician from Italy. He wrote a book called Liber Abaci in which he set out a remarkably simple sequence of numbers that serves as the basis for the Fibonacci retracement indicator. Although this number sequence was already known by Indian mathematicians some 700 years earlier, these numbers were popularized by the book by Fibonacci, who introduced this sequence to the western world.
What are the Fibonacci numbers?
You probably remember this from your math studies. Got a pen and paper? Write the number zero on the left, then put the number 1 next to it. Then add the zero and the one together. What do you get? Yes, that’s right — it’s another 1. So write that down next to the first 1. Now you just keep going. Add the 1 and the 1 together to get 2. Then add 2 and 3 together to get 5. Keep going with this sequence, adding the most recent two numbers and writing the sum next to the last number. Your sequence should look like this.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377 … and on to infinity!
These are the Fibonacci numbers.
What’s the Golden Ratio and how does this relate to the Fibonacci Sequence?
Well, this might make your head spin if you have an appreciation of the links between mathematics and nature. If you take the ratio of the 5th and 6th numbers in the Fibonacci Sequence (3 and 5), that comes to 1.618. Then if you take the ratio between the 6th and 7th numbers in the sequence (5 and 8), that comes to 1.60. Keep going with this, and you’ll notice this number gradually starts to converge on 1.618033988749895. That happens after the 40th number in this process. The number you get is called the “golden ratio” and is often represented in mathematics as “Phi”.
The Golden Ratio is all around us
Also known as the golden mean and the divine proportion, you might already be getting a sense of why it is so important. You can find this ratio everywhere. On flowers, shells, our fingers all the way up to even the spiral galaxies in the universe we inhabit. Also, if you divide the number of female bees by the number of male bees in a hive, you will get 1.618. Going back to the human body, you’ll see again how it permeates. If you measure the distance between your shoulder and finger tips, and then divide this number by the distance between your elbow and finger tips, what do you get? Test it out now! You’ll see it’s pretty much that golden ratio. And this is just as important in the financial world too.
To understand how the golden ratio works in finance, let’s take a deeper dive into what Fibonacci retracement levels are so we can understand better.
What are Fibonacci retracement levels?
When it comes to assessing where support and resistance can be found for your chosen trading pair, traders use 0.618 (the inverse of 1.618) in their Fibonacci retracement approach. They convert it to a percentage (61.8%) and this forms a horizontal line in your chart to indicate where there is a good chance that support and resistance will happen. If you subtract 61.8% from 100%, you get 38.2%, and this is the other key level for support and resistance used. The 50% level is used too, but is not in fact an official Fibonacci retracement. However, it is usually included as a level because an asset often rebounds by around 50% of a significant move before continuing its trend again.
How do I draw Fibonacci retracement levels?
Most trading platforms have a tool which allows you to do this quickly and easily. We have used eToro in this example, but all the reputable platforms have a similar option. We’ll also use crypto trading pairs against the dollar, as the Ethereum 2.0 roll out and the growing DeFi market are fueling their popularity among traders.
To begin, follow these instructions and use the image below them to help:
· Click on the two little arrows indicated with the green circle to widen the screen so you can see it more clearly.
· Click the settings drop down indicated with the black arrow.
· Select tools and then “Fibonacci” (circled in red) in the drop down box.
How can I use Fibonacci retracement levels?
The key point to take away is that Fibonacci retracement levels are a general indicator of key levels of support and resistance. It is at these levels that the price could change direction.
They tend to work best after a market has made a large move either up or down (otherwise known as when it is “trending” in one direction or another).
Therefore, when your asset pair is trending up, you should be looking to go long once you see a retracement at a Fibonacci support level. And when the market is trending down, you should be looking to go short once you see a retracement at a Fibonacci resistance level.
Using Fibonacci retracement during an uptrend
Take a look at this ETH/USD daily chart for the period 15 May — 15 July 2020.
Here, you can see the Fibonacci retracement levels are indicated with horizontal red lines. They are set at ~178 ETH (38.2%), ~165 ETH (50%) and ~148 ETH (61.8%). From the swing high of ~227 ETH shown, we would expect ETH/USD to retrace down to find support at one of these Fibonacci retracement levels.
As you can see with the green circle, the price did fall to the 38.2% level around 12 May, and the price did indeed find support there. Then the market changed direction and resumed its upward trend, breaking past the swing high of ~227 ETH just before the end of May. So you can see that going long on ETH at that 38.2% Fibonacci level would have been profitable for you.
Using Fibonacci retracement during a down trend
You can also use Fibonacci retracement when the trend is going down too. To illustrate this example, let’s take a daily chart for BNB/USD (Binance token/US dollar), and for the period 12 February to 27 March 2020.
Again, you will see the Fibonacci retracement levels indicated with horizontal red lines. They are set at ~23.5 BNB (38.2%), ~22 BNB (50%), and ~21 BNB (61.8%)
You’ll notice the swing high is set at ~BNB 27 and the swing low is set at ~BNB 17.50. So contrary to the previous example, we would expect the price of BNB to retrace up to find resistance at one of these Fibonacci retracement levels. As you can see with the green circle, the price did rise to the 61.8% level on around 6 March, and the price found resistance there. Then the market changed direction and resumed its downward trend, falling below the swing low of ~BNB 17.50 just a few days later. So you can see that if you had shorted BNB at this 61.8% Fibonacci level, that would have been a profitable move for you.
The great thing about these approaches is that they can be used for both long- and short-term trades, so that means anything from minutes, to hours, to months and years. But be aware that they are more powerful indicators for longer time frames — more about that later. You can also use them for a broad range of asset classes too, so they are great to understand and apply to your trading strategy before moving on to the next technical indicator.
Where can Fibonacci Retracements go wrong?
Like every technical indicator, Fibonacci Retracements are not fool proof. If it were that easy, then there would be no trading manuals or educators needed. The price could burst through and go past the retracement line just as easily as it might bounce in the other direction. You will make far better trading decisions if you also check to see what the price does after you get the thumbs up for your retracement level signal.
The level of reliability of Fibonacci retracement levels is also dependent on the time frame used. That means that a 61.8% retracement on a monthly chart is a far stronger indicator than the same retracement on a 4-hour chart. Therefore, you should consider ascribing more importance to this indicator — and indeed all other technical indicators — when the time frame involved is longer.
It is also crucial to avoid the rookie mistake of being inconsistent when drawing your Fibonacci scale on your trading chart. When setting the swing high and swing low points, always make sure you set it to candle body to candle body, and wick to wick. Inconsistencies with this approach will mean far more inconsistent results, which is of course what traders are always seeking to minimize! This great video below helps understand this concept better.
The other key problem to be aware of is picking the right swing low and swing high points. When it comes to making your selection, bear in mind that everyone looks at charts in different ways, using different time frames, and then their own preconceptions come into play too. Your idea about where a swing low and swing high is could be completely different from ours, and we would both have good reasons for believing what we do! But will we both be right? Not always.
Trading is never easy but getting to grips with one technical indicator at a time is a solid way to start getting better. Use other indicators such as the moving average (MA), the exponential moving average (EMA), the Stochastic oscillator, the moving average convergence divergence (MACD), Bollinger bands, the relative strength index (RSI), the Ichimoku cloud — the list goes on. Your goal should be to use this strategy along with at least three other technical indicators to best identify possible areas of reversal which provide opportunities to enter the market with potentially high reward and low risk entries.
So now you’ve got the basics down for Fibonacci retracement. You’ve got the background, a summary of how to use it, and a good awareness of the risks involved. Congratulations for taking your first step forward!
But remember — practice using this indicator plenty of times before even considering committing any funds at all, and be fully aware of the risks of trading. Play around with the concept and let us know how you got on in the comments below!
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A Beginner’s Guide to Fibonacci Retracement Levels was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.