Stocks & Trading Education Hub What is Fibonacci retracement? – A Complete Tutorial 2023
Jhonattan Jiménez
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Technical analysis (TA) includes various tools and indicators traders can use to predict the market’s price. The Fibonacci Retracement is one of the most commonly used indicators in the stock, forex, and cryptocurrency markets.

This article aims to provide insight into “What is Fibonacci Retracement?” and how it can be utilized to identify significant levels on a chart.

What is Fibonacci Retracement? – Introduction

Definition and explanation of Fibonacci retracement in technical analysis

Traders use Fibonacci retracements in financial markets to identify potential support and resistance levels. Each number in the Fibonacci sequence (0, 1, 1, 2, 3, 5, 8, 13, 21, etc.) equals the sum of its two preceding numbers. This sequence can be used to calculate Fibonacci ratios.

In a price chart, Fibonacci retracement levels are horizontal lines drawn at certain levels corresponding to these Fibonacci ratios, namely 23.6%, 38.2%, 50%, 61.8%, and 78.6%. The levels represent the start and end points of a significant price movement. In anticipation of potential reversals or continuations, traders use these retracement levels.

Overview of the Fibonacci sequence and its significance in trading

Fibonacci sequences play an important role in technical analysis and trading due to their derived ratios for identifying price levels, trends, and retracement zones. There are various financial markets in which these Fibonacci ratios are used, including stock markets, forex, commodities, and even cryptocurrencies. Fibonacci sequences are often used by cryptocurrency traders to identify significant entry and exit points and invest in the best crypto presales.

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The Golden Ratio and Fibonacci Levels

Understanding the Golden Ratio (1.618) and its relation to Fibonacci levels

Often expressed by the Greek letter Phi (Φ), the Golden Ratio is a mathematical constant approximately equal to 1.61803398875. Fibonacci’s sequence is the basis for this ratio, which has numerous applications in art, architecture, nature, and trading.

Fibonacci retracement levels and extensions are closely related to the Golden Ratio in trading and technical analysis. Fibonacci levels are used in conjunction with the Golden Ratio as follows:

  • Fibonacci Extensions: Traders often use Fibonacci extensions to project potential price targets after a significant price movement. The Golden Ratio (1.618) plays a significant role in these projections. If a price trend moves in a particular direction and there is a retracement, traders might project extension levels based on ratios such as 1.618. By doing this, they anticipate the next potential price target by extending the price movement by 1.618. The levels can serve as stalling or reversal points for prices.
  • Fibonacci Retracement: Fibonacci retracement levels are influenced by the Golden Ratio (1.618), even though it is not commonly used. Golden ratios are the main basis for Fibonacci retracement levels. In the Fibonacci sequence, each number is divided by the next number two places to the right (e.g., 34 divided by 55 is approximately 0.618). Similar to the 38.2% retracement level, we can calculate it by subtracting 0.618 from 1 (1 – 0.618 = 0.382).

Explaining the key Fibonacci retracement levels

  • 23.6% Retracement: Fibonacci sequence shows this level as a shallow retracement. The value is derived by dividing the number in the sequence by the number three places to the right. For example, 13 divided by 55 equals approximately 0.236.
  • 38.2% Retracement: In addition to predicting potential support or resistance areas, this level is calculated by subtracting 0.382 from 1. It can signal more substantial pullbacks than 23.6% retracements within a trend.
  • 50% Retracement: Despite not being directly derived from the Fibonacci sequence, the 50% level represents the midpoint between highs and lows. Due to its psychological significance, traders often watch for signs of price reversal or continuation at this level.
  • 61.8% Retracement: The level is calculated by dividing two places to the left by the number of two places to the right (e.g., 34 divided by 55 is approximately 0.618). Fibonacci retracement levels, such as 61.8%, are very significant. It helps traders predict potential support or resistance areas.
  • 78.6% Retracement: This level is known as the “Golden Pocket.” It’s calculated by subtracting 0.786 from 1, and although it’s not directly related to Fibonacci, it’s often used as a reference.

Using Fibonacci Retracement to Identify Support and Resistance

Applying Fibonacci retracement to find potential support levels during uptrends

During an uptrend, you can identify potential support levels by identifying significant swing points and plotting Fibonacci retracement levels, including those mentioned above. Forecasting potential support zones based on the price’s interaction with these levels is possible. Enhancing reliability using other technical tools, such as trendlines or moving averages, is also possible.

Identifying potential resistance levels using Fibonacci retracement during downtrends

Fibonacci retracement levels are applied on a price chart to highlight notable swing points. A trader can anticipate price stalls or reversals by observing price reactions to these levels. This level is more credible if validated with other technical indicators or patterns.

Placing profit targets just above identified resistance levels may be beneficial when considering short trades. Monitoring and adhering to risk management practices is essential for sound trading decisions.

Drawing Fibonacci Retracement Levels on Charts

A step-by-step guide to drawing Fibonacci retracement levels on price charts

  • Select a charting app: The best stock trading apps are among the one which support Fibonacci tools.
  • Identify the Trend: Analyze the trend and determine whether it is upward or downward.
  • Select Swing Points: Determine the most recent and significant price swings defining the trend. Identify the high point and the low point of an uptrend. Determine the lowest trough and the highest point in a downtrend.
  • Locate Fibonacci Tool: Ensure your charting software has a Fibonacci retracement tool. The icon often resembles parallel lines or horizontal lines.
  • Select the high and low points: To use the Fibonacci tool, select the high point (for an uptrend) or the low point (for a downtrend). This will anchor the tool.
  • Drag to the Opposite Side: Drag the tool from low to high or high to low while holding the mouse button down.
  • Release the Mouse Button: You can plot Fibonacci retracement levels on the chart by releasing the mouse button. Horizontal lines mark Fibonacci levels.
  • Examine the levels: Observe how the levels align with price movements once plotted. These levels might act as support or resistance, so be aware of how the price reacts around them.
  • Fine-Tune and Adjust: The placement of Fibonacci levels may need to be fine-tuned depending on the specifics of the trend. You can manually adjust the levels on some apps.

Customizing Fibonacci retracement tools on different trading apps

On different trading apps, you can customize Fibonacci retracement tools as follows:

  • Select the desired financial instrument and open its chart.
  • Click the Fibonacci retracement tool under Drawings or Analysis Tools.
  • Select swing points depending on the trend direction (uptrend high-low, downtrend low-high).
  • Set levels, colors, styles, and labels according to your preferences.
  • Check the customized Fibonacci retracement levels on the chart using the tool.
  • Monitor price action around levels and adjust if necessary.
  • Save or set your custom settings as default for future use.
  • Each trading app has specific instructions, so refer to its resources for detail

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What are Fibonacci Extensions?

Definition and explanation of Fibonacci extensions

Extensions of the Fibonacci sequence are horizontal lines drawn on a price chart to project upcoming prices. To predict where a price might reach during a strong trend continuation, these extensions use the Fibonacci sequence and ratios, particularly the golden ratio (1.618).

Traders use a Fibonacci extension to identify significant price movements, usually uptrends. To determine the direction of the trend, they select two key points: the starting point (low of the initial trend) and the ending point (high of the initial trend). Potential extension levels are projected using these points.

Traditionally, Fibonacci extension levels have been calculated using 161.8%, 261.8%, 423.6 %, and 764.4%. Using these ratios, one can calculate the potential price extension beyond the trend movement.

Traders can, for example, use the Fibonacci extension levels to determine where the price is likely to go after point B if the initial trend is from point A to point B. By extending the trend 161.8%, we can expect the price to move 1.618 times the initial trend beyond point B. Similarly, the 261.8% extension implies 2.618 times the length of the initial trend.

Using Fibonacci extensions, you can estimate where the price might go after a significant movement in the trend. Strong trend continuations help traders anticipate areas where prices will stall or reverse. Here’s how:

  • Identify the Trend: Ensure that the price is moving strongly. Uptrends or downtrends are characterized by higher highs and higher lows (uptrends) or lower lows and lower highs (downtrends).
  • Select Key Points: Determine the two crucial points defining a trend movement: the low and high.
  • Apply Fibonacci Extension Tool: Using your trading apps’ analysis tools, find and use the Fibonacci extension tool.
  • Anchor the Tool: In the first trend, click on the low point (starting point) and drag the tool to the high point (ending point).
  • Extension Levels: Charts are automatically plotted with Fibonacci extension levels. A common extension level is 161.8%, 261.8%, 423.6%, and 764.4%.
  • Interpretation: Extension levels indicate possible areas for price movement following the initial trend.
  • Set Profit Targets: Traders can use These extension levels as profit targets. Trading positions might be closed, or profits are taken when the price approaches an extension level.
  • Adjust according to price action: The price should be monitored as it approaches the projected extension levels.

Fibonacci Extension Levels

Understanding key Fibonacci extension levels

In trending markets, Fibonacci extension levels are projected to anticipate potential price targets. Below are some common Fibonacci extension levels:

  • 2% Extension: In trading, this level is an extension of the Fibonacci sequence, but it’s not directly part of it. Traders may be interested in a potential area of interest if the price moves 1.272 times the length of the initial trend.
  • 8% Extension: A price that moves 1.618 times the length of the initial trend is considered at an extension level based on the golden ratio (1.618). The price might encounter resistance during a trend continuation or stall around this level.
  • 8% Extension: This level represents 2.618 times the length of the initial trend derived from the golden ratio. This level provides traders with an indication of areas where the trend might continue or reverse.
  • 6% Extension: The price may move 4.236 times the length of the initial trend at this level. It is less commonly used than previous levels but can provide potential price targets in strong trends.

Examples of Fibonacci extension levels in real-world trading scenarios

The uptrend in a Stock

Assume that a stock is in a strong uptrend, and you wish to set profit targets based on Fibonacci extensions. As the initial trend movement, you identify an upward trend from $50 to $80. Based on Fibonacci extensions, you project the following levels:

  • 2% Extension: $95.86 (1.272 * $30 + $80)
  • 8% Extension: $97.16 (1.618 * $30 + $80)
  • 8% Extension: $102.54 (2.618 * $30 + $80)
  • 6% Extension: $109.08 (4.236 * $30 + $80)

Prices might encounter resistance or stall at these extension levels during an upward trend. This is also useful when trading penny stocks. Be sure to use one of the best penny stock apps on the market to apply it.

Downtrend in Forex

During a downtrend scenario in the forex market, a currency pair moves strongly from 1.2000 to 1.1500. To set potential price targets, you use Fibonacci extensions:

  • 2% Extension: 1.1355 (1.272 * 0.0500 + 1.1500)
  • 8% Extension: 1.1295 (1.618 * 0.0500 + 1.1500)
  • 8% Extension: 1.1130 (2.618 * 0.0500 + 1.1500)
  • 6% Extension: 1.0893 (4.236 * 0.0500 + 1.1500)

A downtrend may encounter resistance at these extension levels, or traders could consider taking profits. Make sure to use one of the best forex trading apps when using Fibonacci tools.

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Fibonacci and Chart Patterns

Combining Fibonacci retracement with common chart patterns

Head and Shoulders combined with Fibonacci Retracement:

Trading can be enhanced by combining head and shoulders patterns with Fibonacci retracement. To determine the price trend, identify the head and shoulders pattern and retrace the price from the first shoulder’s low to the head’s high. Those levels become more important when they are confluent with the neckline. If the price breaks below the neckline and a Fibonacci level, a trend reversal is likely, potentially allowing an entry into a short position.

 Fibonacci Retracement combined with Double Tops/Bottoms:

 Double tops and bottoms are more comprehensive when combined with Fibonacci retracement. Determine the pattern and apply a Fibonacci retracement from the low of the first bottom (or high of the first top) to the high of the peak (or low of the trough). Check Fibonacci levels for confluence with pattern peaks or troughs. Double bottoms and double tops indicate the potential for a trend reversal when the price breaks above or below a Fibonacci level, suggesting entry points aligned with the breakout.

Using Fibonacci to confirm or invalidate chart pattern signals

Fibonacci retracement can be applied to relevant price swings, including head and shoulders, double tops/bottoms, or triangles, when confirming or invalidating chart patterns. Fibonacci levels that align with breakout levels, support levels, or resistance strengthen the signal of the pattern. As a result of this confluence, the pattern is effective.

A pattern’s signal may weaken or become invalid if Fibonacci levels do not align with expected pattern points or if the price does not react as expected. Chart pattern signals are more accurate if multiple timeframes are considered, price reactions are observed, and other indicators are used along with Fibonacci retracements.

Fibonacci Retracement and Trend Analysis

Using Fibonacci retracement in conjunction with trendlines

In conjunction with trendlines, Fibonacci retracement is used to identify confluence points along significant swing points in the direction of the trend. Fibonacci levels that align with trendlines serve as potential support or resistance levels in uptrends or downtrends, respectively. By observing price movements at these confluence points, confirmation can be gained. Using multiple timeframes to analyze this combination can enhance accuracy.

Enhancing trend analysis with Fibonacci levels

Using Fibonacci levels enhances trend analysis by applying retracements to significant price swings within a trend and identifying points where these levels cross over trendlines or historical resistance/support levels. Validating potential turning points requires observing price reactions at these points. A comprehensive analysis incorporates multiple timeframes, Fibonacci extensions, and other indicators. The use of Fibonacci levels in trend analysis is complemented by effective risk management and continuous learning, which serve as supplemental tools for identifying potential support, resistance, and reversal zones.

Limitations of Fibonacci Retracement

Factors affecting the reliability of Fibonacci levels

Several critical factors determine the reliability of Fibonacci levels, which predict support, resistance, and reversal points in trading. A strong trending market may make Fibonacci levels more reliable than choppy or volatile markets. Timeframe plays a significant role in the analysis, as confluence between levels over multiple timeframes carries greater reliability. Their accuracy is enhanced when Fibonacci levels are applied to well-defined and predictable trends.

Confluence, a situation in which Fibonacci levels align with key technical indicators, such as support/resistance levels and trendlines, strengthens the reliability of these levels. As a result, their historical significance boosts their predictive power, as levels that previously acted as key support or resistance zones are more likely to do so in the future.

Instances where Fibonacci retracement may not work effectively

Although Fibonacci retracement can be an effective tool in technical analysis, it may only work in some circumstances. It may not be reliable to use Fibonacci retracement in the following situations:

  • In choppy and sideways markets: It is possible that Fibonacci levels do not provide accurate support or resistance levels when there is no clear trend in the market, such as ranging or sideways markets.
  • Low Liquidity: The Fibonacci levels are less adhered to in markets with low liquidity as fewer traders can influence the price.
  • Sudden News Events: Fibonacci levels can become disrupted by unexpected news releases or economic events.
  • Violent price movements: Prices can spike quickly or crash suddenly, invalidating Fibonacci levels in extreme cases.
  • Short-Term Trends: The Fibonacci retracement can be less effective when there is noise and erratic price movements in short-term trends.
  • Inconsistency in patterns: Price patterns that lack a clear and consistent formation may not respond well to Fibonacci levels.
  • False Breakouts: False breakout signals can occur when the price breaches a Fibonacci level without a significant follow-through.
  • Extended Trends: Because of exhaustion or changes in market sentiment, prices may not always react as expected around Fibonacci levels in prolonged trends.
  • Market Manipulation: Fibonacci levels can be manipulated by larger players in markets with lower regulation or greater susceptibility to manipulation.

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Risk Management with Fibonacci Retracement

Implementing proper risk management when using Fibonacci retracement

Any trading tool, including Fibonacci retracement, must be used with proper risk management. Calculate the distance between your entry point and stop-loss level to implement effective risk management. Limit losses by setting stop-loss orders below (for long trades) or above (for short trades).

Using trailing stop-loss orders and avoiding overleveraging will help you manage risks.

Avoiding common mistakes and biases in interpreting Fibonacci levels

Interpreting Fibonacci levels requires a balanced and critical mindset to avoid common mistakes and biases. First, avoid confirmation bias by focusing only on evidence that supports your preconceived notions. Keep an open mind and acknowledge that Fibonacci levels are just one tool among many in technical analysis. Also, consider the broader market context before relying on Fibonacci levels only. Consider factors such as news events, fundamentals, and market sentiment when analyzing price movements. Combining Fibonacci levels with other indicators and patterns can provide a holistic view.

Additionally, if Fibonacci levels are tweaked too precisely to fit historical data, it could lead to inaccurate real-time predictions. Rather than complicating your analysis, focus on consistency and simplicity. Remember that Fibonacci levels aren’t infallible predictors, so manage your expectations. This level may only sometimes be adhered to precisely due to market randomness and other factors.

Trading with Fibonacci Retracements – eToro Complete Guide

Now let’s look at how to get started with a trading app. This is how to do it with eToro, a top-rated provider that offers commission-free trades across thousands of markets.

Step 1: Open an Account and Upload ID

etoro logo Getting started is as easy as clicking the ‘Join Now‘ button on the eToro website. In addition to providing your contact information, the trading app requires your full name, nationality, address, birth date, email address, and phone number.

Step 2: Confirm Identity

Your identity must be verified before withdrawals can be made. Here are the documents you need to upload:

  • A valid passport or driver’s license
  • A three-month utility bill or bank statement

Your account should be verified instantly if eToro validates the documents automatically.

Step 3: Deposit Funds

The next step is to locate your newly created eToro trading account. There are several convenient ways to pay, including:

  • Debit cards
  • Credit cards
  • E-wallets (Paypal, Skrill, or Neteller)
  • Bank transfer

eToro requires a minimum deposit of $10. eToro is also one of the best paper trading apps on the market. In that way you can test it before start to invest.

Step 4: Browse Supported Trading Markets

Having funded your eToro account, finding the asset you want to trade is time. Search for the market you are interested in.

Click the ‘Trade Markets’ button to see which assets are supported. Then, you’ll see a list of asset classes you can trade, including stocks, cryptocurrencies, forex, and commodities. eToro also is the best ETF app to use Fibonacci retracement.

Step 5: Place a Trade

It is now time to place an order for the asset you wish to trade.

What is a Fibonacci Retracement? – Conclusion

Incorporating Fibonacci retracement into one’s trading strategy is useful to gain valuable insights and make more informed decisions. To make more informed entry and exit decisions, traders should identify potential support, resistance, and reversal levels throughout trends. Fibonacci levels can be used with other technical tools and patterns to enhance the reliability of signals and improve accuracy. In addition, using Fibonacci retracement promotes a systematic and disciplined approach to trading, which improves risk management and trade execution.

The potential drawbacks should, however, be acknowledged. Since many variables influence markets, it is important not to focus overly on Fibonacci retracement. Using Fibonacci levels has also caused self-fulfilling prophecies, leading to crowded trades and volatile price reactions. Traders must also avoid overfitting or adjusting Fibonacci levels too closely to historical data, which hinders real-time analysis.

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Jhonattan Jiménez

Jhonattan Jiménez

English Language professional with a vast experience teaching English as a second language, English translator to Spanish, Cryptocurrency enthusiast, interested in geopolitics and economy.