Many people ask me if Fibonacci retracements and extensions really work when it comes to trading, and to the that I have the following answers. First off all I would recomend that you go and read my article on Fibonacci Explained. Then come back here and we’ll discuss this further. I think everyone knows that price moves in a retracement type fashion in any direction accept when it’s trading sidways.If price is going up, it tends to do so in a series of what we call impulse’s and corrections.
These impulses and corrections look like this:
There are many different scenarios this particular pattern could be apart of, but the potential for the application of Fibonacci retracements and extensions lies in not only this 5 wave move up, but also and especially in the overall correction of this move. You see although this is 3 impulse waves, and 2 corrective waves, on the larger scale its one impulse wave. Here’s what I mean:
Notice the corrective wave in red – (Fibonacci retracements in action – larger scale)
5 Rules to Perfect Fibonacci Chart Plotting
Fibonacci retracements represent an excellent tool for investors, identifying potential reversal points on a price chart. Anyone can see that on any historical price chart, trading prices will inherently pull back or retrace a percentage of the previous movement before reversing again and then proceeding in the direction of the overall long-term trend.
Historical observations demonstrate that these Fibonacci retracements seem to follow a Fibonacci ratio pattern. By carefully plotting these retracement possibilities on a historical price chart, a trader improves his or her probability towards successful investing. Certain rules are recommended to improve the likelihood of identifying successful entry and exit points.
Rule 1: Identify the High and Low
In order to use Fibonacci retracements the right way, it is important to identify relative high and low prices on a historical chart. The longer the term that is utilized, the more likely the Fibonacci retracements plotted will identify significant levels demonstrated support and resistance.
Rule 2: Plot the Fibonacci Retracements
Once a high and low for a time period has been identified, you lay out your Fibonacci retracements. The low point would represent 0%, and the high point represents 100%. (A good rule of thumb with Fibonacci retracements is to make sure that as price retraces, the levels are getting higher – ie; 23.6%, 50%. 61.8% etc… Rather than lower. If they are getting lower you laid them down the wrong way.)
Between these two extremes, one can plot the most significant Fibonacci percentage plot lines of 38.2%, 50%, and 61.8%. It is also beneficial to plot these percentages below and above the high and low. In other words, plot lines that would be 138.2%, 150%, and 200% on the up side above the high, and -30.2%, -50%, and -61.8% on the down side below the low. It should be noted that software exists that will allow you to automatically plot these Fibonacci retracements. (most platforms have the tools ready to go.)
Rule 3: Observe Historical Behavior
Once the plot lines have been placed on the chart, it is important to observe at which Fibonacci levels in the historical period under consideration has demonstrated support and resistance. These areas will be objectively seen to show that when approached, retracement clearly resulted.
Rule 4: Forecast Future Movement
The appropriate Fibonacci retracements will vary from investment market to investment market and be a function also of the trading character at any particular time. Consequently, successful use of Fibonacci techniques will be highly dependent on the accurate interpretation of previous price movement activity within the range identified. When the proper Fibonacci retracements have been observed, entry and exit points can be forecasted for position-taking based upon the clearly demonstrated historical record.
Rule 5: Always Have Confirmation
Through study and observation, many successful traders have mastered the techniques necessary for the use of Fibonacci retracement ratios. As anyone can see, however, the support and resistance represented by these levels do not automatically appear at all times. In other words, after the 38.2% retracement, the price may continue in that direction and not stop or reverse itself until perhaps it reaches 61.8%.
What is clear, however, at a certain Fibonacci point, a retracement will occur. As a result of this, the use of Fibonacci techniques is most successful when used in conjunction with other technical analysis tools that confirm what has been identified.
More Fibonacci Retracements
The Fibonacci Retracement is probably the most heavily used Fibonacci tool in the toolset. You will find Fibonacci Retracements as a solid tool in identifying key support and resistance areas.
If prices have fallen from a recent swing high down to a swing low, the expectation is that price should retrace distance, high to low, by a ratio of the Fibonacci sequence. .
You can use Fibonacci retracements and extension from a tick chart through a daily, monthly and weekly. Literally any time frame
It is important to note, the larger price move from swing high to swing low, the more accurate the retracement projections. Identification and selection of the correct swing points are keys to success.
While there are many variations of the ratio set, simple is better, lets focus on four major retracement levels.
- 23.6% — The shallowest of the retracements. In very strong trending markets price typically quickly bounces in the area of this ratio.
- 38.2% — This is the first line of defense of the current trend. Breaking this level starts to erode the underlying trend.
- 50% — The neutral point of any retracement. This is the critical tipping point.
- 61.8% — retracing to this typically signals a breakdown in the trend.
- 100% — Matching the move
In this section we will also show examples of how potential opportunities form when price retraces beyond 100% by following another set of Fibonacci ratios:
Notice in each case we have simply added 100% to the standard ratio set. I use this set of retracements on a daily basis, from 23.6% all the way to 200% and sometimes 300% For my style of trading I find 38.2%, 50% and 61.8% quite reliable.I use the other primarily as confirmation levels.
So lets take a look at some examples of Fibonacci Retracements in use.
Take the example below. The EUR/USD had risen from 1.3360 to 1.4278. The next day the EURUSD failed to make a new high and the potential swing point was in place. So I using swing points I placed a Fibonacci retracement on my chart.
The trend was obviously very strong and the first retracement to the 23.6% level was met with a violent change in direction. You can see the dip below the 23.6% level and the sudden reversal. While there are multiple entry methods, the most conservative would be to wait until the level is penetrated and price establishes itself above that level and enter on the open of the next bar as shown.
Once you understand the method you can find countless examples. Every market, FOREX, Equities and Futures each exhibit these patterns to some degree.
Lets look at another example using the USDCAD. You can see in this example there are multiple entry points for both trend and counter trend trades.
Lets zoom in and look at the area highlighted in blue. Fibonacci Ratios work on virtually any size price swing. The chart below shows the Fibonacci Retracement applied to the smaller price swing.
The blue ellipses show the high potential entry points. Notice, in each of these cases you could have entered the market with a relatively tight stop loss with high reward potential. Ok, we have shown some examples of well behaved price action. What happens if price retraces 100%? How far can it go beyond this point? Fibonacci ratios provide some clues to answering this question and finding low risk entry points.
The example below shows the GBPUSD making a bottom and bouncing back. And multiple entry points from the same set Fibonacci Retracements levels.
Of note are the high potential entry points at 38.2%, 50% and 61.8%. Each of these could have been entry points with solid profit potential. However, notice after the initial breakout above 100%, there were other opportunities to get in the trade. Ultimately price jumped to the 138% point before backtracking. This example shows yet another way to use Fibonacci Retracements. This example shows why it is valuable to identify potential levels above and beyond the initial 100% retracement.
Fibonacci Retracements are the cornerstone of Fibonacci theory as it applies to the financial markets. Hopefully these examples have provided guidance from which to draw your own retracements and expand your trading toolset. To recap, while there are other retracement values, my defaults Fibonacci Retracements always include:
You can never tell when price action it going blow well beyond the 100% level.