The Fibonacci Retracement tool, available in most trading platforms, can aid in finding entry points while trading (but should not be relied on exclusively). Learn the basics of Fibonacci retracements, its uses, strategies, pitfalls, and how I use the indicator. Use Fibonacci Retracements in any liquid market and on any time frame.
Throughout nature, we see a repeating pattern, based on a series of numbers which Leonardo Pisano Bogollo (13th century) introduced to the West. The number series, and the Golden Ratio, are found in galaxy formations, plant growth, and man-made structures. These “Fibonacci levels” are also found in financial markets, and can help us determine where the market may go. No indicator should be used in isolation, but by combining it with trend analysis (so you are taking trades in the right direction) it helps highlight logical areas for entering trades.
Fibonacci Numbers and Fibonacci Retracement Levels
When the price of an asset pulls back (moves lower off a recent high, or moves higher off a recent low), that pullback typically has a mathematical relationship to the price wave that preceded it. This relationship is based on the “Golden Ratio” and a series of “Fibonacci Numbers” that help define the numerical relationship of one thing to another.
As a quick introduction, the following are Fibonacci numbers:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34…
The next number in the sequence is the sum of the prior two numbers before it. So the third number is 1, because the prior two numbers–added together–are 0 and 1. The 5 is a result of adding 2 and 3. 34 is the result of adding 13 and 21. The sequence continues indefinitely.
The “Golden Ratio” is derived from this sequence. As the sequence progresses, if a number is divided by the prior number it produces a ratio. 3/2 is 1.5, 13/8 is 1.625. As the numbers progress the relationship (ratio) reaches the Golden Ratio of 1.618. Since the Golden Ratio shows the relationship between an infinite amount of numbers (once the sequence gets going), it also tends to appear throughout nature.
Common Fibonacci Retracements levels are 23.6%, 38.2%, 50.0%, 61.8% and 78.6% (or 76.4%; since these are so close, it doesn’t really matter which is used). With the exception of 50%, these percentages are derived from the Fibonacci sequence. A number divided by the next highest number gravitates toward 61.8% (0.6180) as the numbers increase. A number divided by a number two places ahead of it gravitates toward 38.2% (0.3820), and a number divided by a number three places ahead of it gravitates toward 23.6% (0.2360). 76.4% is the result of subtracting 0.236 from 1.
50% isn’t really a Fibonacci retracement level, but is based on other technical analysis theories that state a pullback will often retrace about half of the prior advance (it is the mid-point between 38.2% and 61.8%). Therefore, 50% is often included when discussing Fibonacci retracement levels.
Most often these numbers are rounded off for actual trading, since the numbers only provide an estimate of where the pullback is likely to go (Fibonacci retracements are not likely the Holy Grail you have been looking for….but they can be useful).
Think of these numbers this way. If the USD/JPY moves 100 pips higher, from 101 to 102 then a 23.6% retracement means the price pulls back (about) 24 pips, to 101.76. A 50% retracement means the price pulls back half of the prior advance–since the original advance was from 101 to 102, a 50% retracement of that brings the price back to 101.50.
Fibonacci retracements are most accurate on popular and highly liquid currency pairs, stocks and futures contracts. A low volume market is more swayed by individuals (and not a large group of traders) and therefore may have erratic movements which don’t align with the Fibonacci retracement levels.
Using the Fibonacci Retracement Tool
The Fibonacci Retracement tool is drawn over one price wave to provide a context for how far the pullback that follows it will go, before the trend (impulse wave direction) resumes again.
To apply the Fibonacci Retracement tool to your chart, select it in your trading platform. In MetaTrader: Insert >Fibonacci>Retracement, or simply click on the icon on the toolbar. In other chart platforms, choose it from the technical indicators list.
For an uptrend or impulse wave higher, put the 0.0 at the wave high and the 100 at the wave low. For a downtrend, or impulse wave lower, put the 100 at the top of the wave and the 0.0 at the bottom. This will provide you with the potential retracements for the pullback following the impulse wave.
Figure 1. EURUSD Daily Chart with Fibonacci Retracement Levels
Figure 1 shows the Fibonacci Retracement tool applied a price move higher (100 at low and 0 at high). The tool then provides areas where the pullback is likely to stall (later, which level(s) have the highest probability of causing the reversal will be discussed). In this case, the price stalls at the 61.8 level, and then continues moving higher.
Once a new wave forms, you can delete the old Fibonacci retracement tools to avoid cluttering the chart. Although, you can use multiple Fibonacci Retracement levels on different time frames and on different scales (big moves and/or little moves on the same time frame) to keep track of where longer-term or short-term moves may go.
Interpreting Fibonacci Retracements
Once an impulse wave (the big moves that occur in the trending direction) has occurred, and the tool has been applied to it, the price will quite often move to and stall at one of the Fibonacci Retracement levels. If the price falls through one level it will likely proceed to the next level. Occasionally, a price may stall at one level, then proceed to the next, stall and proceed to the next and so on. During such times it is important to have some guidelines on which levels are likely to be most important in certain market conditions (this will require a lot of practice reading price action).
In a very strong trend, expect shallow pullbacks, to 23.6, 38.2 and sometimes 50. In “normal” trends, or during the middle of a trend expect a pullback to the 50 or 61.8 levels. Early in the trend (figure 1), late in the trend or during weak trends expect retracements/pullbacks to reach the 61.8 or 78.6 levels (see Most Common Fibonacci Ratios in Financial Markets).
Each market has slightly different tendencies. While the above provides a general guideline, history may show a specific stock/currency/future tends to gravitate toward 60% declines early in the trend, and 40% retracements later in the trend. The more specific your research into an asset you are trading, the better. General guidelines may serve you, but successful traders are putting in the extra time to find out exactly how far an asset they are trading retraces. You may find certain assets don’t pullback to Fibonacci numbers at all, but have a tendency to retrace 85% or 25% for example.
We can’t know in advance which Fibonacci level will reverse the pullback, and since there are multiple levels, which one it stops at can be random. This is why we need to some other tools to help make trading decisions if we opt to use retracement levels. Those tools will be discussed a bit later.
Fibonacci Retracements are a guide; don’t expect the price to stop exactly at a level. In figure 1 for example, the price slightly overshoots the 61.8 level. It is typical for the price to stall just above or below a Fibo level.
Figure 2. EURUSD Daily Chart with Multiple Fibonacci Retracements
In figure 2 the tool has been applied to each major impulse wave higher.
Figure 3 shows the Fibonacci retracement tool applied to the entire move higher in figure 2. The most recent pullback comes very close to the 38.2 level before moving higher again.
Figure 3. Fibonacci Tool Applied to Broad Trending Move (EURUSD Daily)
While daily charts have been used in these examples, the Fibonacci Retracements can be applied to any time frame, including ticks charts, 1-minute charts or weekly charts. Retracement levels can also be used on any liquid market, and applied to individual price waves or multiple price waves (for a broader perspective, like in figure 3).
Basic Fibonacci Retracement Strategy
In an uptrend, buy when the price pulls back and stalls near one of the Fibonacci retracement levels, and then begins to move back to the upside. Place a stop loss just below the price low that was just created, or below the lower Fibonacci retracement level to give a bit more room. Ideally, the retracement level you buy at is one that the asset has a tendency to reverse at.
Look for some sort of trade trigger to occur near the Fibonacci level. For example, if the price is up and the price has pulled to near a key Fibo level, wait for the price to consolidate and then break out of that consolidation to the upside. This adds a second layer of confirmation. The Fibo level and then the price stalling and breaking higher. Engulfing patterns can also be watched for to trigger a trade. Without a trigger like this it will hard to trade Fibo levels on their own.
In a downtrend sell when the price pulls up and stalls near one of the Fibonacci retracement levels, and then begins to move back to the downside. Place a stop loss just above the price high that was just created, or above the higher Fibonacci retracement level to give a bit more room. Again, add in a trade trigger or some other element of confirmation.
Looking at how strong the trend is can help determine which Fibonacci levels are most likely to stall and hopefully reverse the pullback. Recall:
In a very strong trend, expect shallow pullbacks, to 23.6, 38.2 and sometimes 50. In “normal” trends, or during the middle of a trend expect a pullback to the 50 or 61.8 levels. Early in the trend (figure 1), late in the trend or during weak trends expect retracements/pullbacks to reach the 61.8 or 78.6 levels.
This is only a guide though, determining what levels are most likely to hold will require a lot of study in regards to price action and the tendencies of the particular asset you are trading.
On the left half of Figure 4, the AUDUSD experienced an aggressive rally after a long downtrend. Due to the aggressive nature of the rally a shallower pullback was expected, likely to the 23.6 or 38.2 level. Figure 4 shows how the pullback unfolded. At first, it stalled at the 23.6 level, but then fell through and proceeded to the 38.6 level where the pullback stopped and another move higher ensued. Entering long near the 38.2 level, with a stop loss just below the recent low, is one potential way to use Fibonacci Retracements for finding entry points.
Using an additional analysis technique to filter trade signals is highly recommended. In this case, we have what I call I multi-bar engulfing pattern. There is the red bar dropping to the 38.2 level, followed by a little bar, followed by a big green bar. That big green bar engulfs that prior big red bar, and that is all I care about. I don’t care if takes 2 bars or 5 bars. What I care about is the transition back to the upside in this case, and that big green bar showed that was happening.
Figure 4. AUDUSD Fibonacci Retracement Trade Example
If the price retreats all the way to the 100% level, that means the entire prior move has been retraced, and shows a range is potentially is developing or the trend on the same degree as that wave is in jeopardy or reversing.
Problems with Fibonacci Retracements in Trading
The main problem with Fibonacci Retracements levels is that quite often the price won’t stop at an exact level; it goes a little past, or reverses before a level. With so many levels drawn–23.6%, 38.2%, 50.0%, 61.8% and 78.6% (or 76.4%)–and then also realizing the price doesn’t usually reverse right at a level, saying that Fibonacci Retracements pick exact reversal points is wishful thinking. Price pretty much has to randomly reverse near one of these points simply because there are so many of them.
If you trade often, you’ll learn that no matter how many perfect textbook examples you see, when it comes to the real world, the price isn’t going to reverse exactly at a Fibonacci level much of the time. Out of the thousands of price waves that occur in various markets each day, some are bound to reverse at one of these levels, or close to it, simply by chance. Many price waves are also bound to reverse between the levels, disregarding the levels altogether.
There is also the issue of figuring out which Fibonacci retracement level is likely to halt and reverse a pullback.
That said, I do still use Fibonacci Retracements….but in a less formal way…
How I Use Fibonacci Retracement Levels
I rarely use the Fibonacci Retracement tool on my charts. I know that I usually can’t pick the exact Fibonacci level the price will reverse at, and even if I get the level right the price may overshoot it or undershoot it. Therefore, I don’t draw the levels, and instead just estimate.
What I usually do is wait for retracements between 40% and 70%, estimated. Once the price enters that approximate area, I wait for a slowdown. A slow down or consolidation is when the price moves sideways for a few bars during a pullback. When the price breaks out of the consolidation back in the trending direction, then I take a trade.
In this way I don’t end up trading all pullbacks; I only trade pullbacks that meet certain criteria. This reduces the number of trades, and I avoid getting stopped out on shallow pullbacks that turn into deeper pullbacks (entering at 38.2%, and then the price continues to move to the 61.8% level, resulting in a loss).
I am also taking into account that I usually can’t pick the exact reversal spot, even with the help of Fibonacci levels. So instead, I let the price tell me when it is ready to reverse. When the price pulls back into my possible trade zone, I just wait for the slowdown. If the slowdown happens, and the price moves back in the trending direction, I have a trade. No need for cluttering up the chart with levels which likely won’t give me any more information than I already have.
It is possible that multiple consolidation or engulfing patterns can form during a pullback. This where I use something called velocity and magnitude. If there is a very sharp pullback, that pullback is likely to continue even if the price consolidates and breaks out in the trending direction. Therefore, I wait for the next consolidation. If the pullback is relatively slow moving, then the pullback is weaker and I may opt to get in on the first trade trigger that appears.
When trading a particular asset, I also look at how far historical retracements have typically gone. This gives me a benchmark for what I can expect on this pullback. I will then only look for trade signals near the retracement level where the asset typically pulls back to and then starts to trend again.
With my method I still have losing trades, but overall it works for me. Using Fibonacci Retracements isn’t required to trade successfully. Use them if they help you; if you find them of little value, never look at them again. Be sure to practice with them and test them out in a demo account before incorporating them into your trading plan or using real capital.
Final Word on Fibonacci Retracements
Use the Fibonacci retracement tool on all time frames, from minute charts up to monthly charts. It is a trend following tool, and helps isolate where pullbacks may end and the trend resumes. Don’t place all your trust in it though. The price may not stop exactly at a Fibonacci level, rather the levels are just a guide. Sometimes the price will completely disregard Fibonacci levels, often when major news occurs. I do additional research on assets I trade to find out how far the asset typically pulls back at various stages of the trend.
Don’t try to force a tool to work if it isn’t working; you don’t need to use Fibonacci levels to trade successfully. Only use the Fibonacci retracement tool in conjunction with price analysis and as part of a complete trading plan.
You can also use Fibonacci math to find profit targets: Use the Fibonacci Extension Tool to Find Targets and Likely Reversal Points.
By Cory Mitchell, CMT @corymitc
For a complete guide on forex trading and loads of forex strategies, see my Forex Trading Strategies Guide for Day and Swing Traders eBook.