Considering how often the market withholds them, Fibonacci retracement levels are among the most prominent technical zones eyed by forex traders. Know that these magic Fibonacci numbers were originally discovered by an Italian mathematician, Leonardo Fibonacci, back in the 13th century when there was no concept of electronic trading systems.
In this article, we will explore how the natural Fibonacci sequence is providing trading opportunities to financial market traders. We will discuss what these levels indicate, and how they can be applied and utilized in conjunction with other signals to optimize trades.
What is Fibonacci retracement?
In financial trading, Fibonacci retracement levels depict the potential support and resistance areas whereby the price could reverse its trajectory. Simply put, they are horizontal lines at which the price may retrace before continuing in its original direction. Note that as a large number of traders monitor these levels to place their buy/sell orders, these potential areas of support and resistance may get upheld for this very reason.
However, like all technical analysis methods, Fibonacci retracements are not always guaranteed to work. Although they can improve the likelihood of a successful trade, sometimes the price may move beyond all the Fib zones or reverses at a different zone than anticipated.
Nonetheless, Fibonacci levels have their reputation and are therefore held in high regard and widely used in the trading community. In an upward-trending market, traders consider “buy” trades when the price retraces at a Fibonacci level, which poses as a support in this case. Whereas in a downward trending market, traders consider placing “sell” trades when the price pullbacks to a Fibonacci zone, which acts as a resistance.
The Fibonacci retracement ratios considered by traders include 23.6, 38.2, 50, 61.8, and 76.4. These levels do not have to be calculated manually as almost all trading platforms include a Fibonacci tool, which extends these ratios automatically.
Now, let us look at how to plot these levels for both uptrend and downtrend trades.
Drawing the Fibonacci levels for a bullish trade
To draw the Fibonacci zones, you must first identify the recent Swing Low and Swing High points on the price chart.
If the market is trending upside, you can draw the Fib levels by selecting the retracement tool and dragging the cursor from the recent Swing Low to 🡪 Swing High.
See the EUR/USD chart below. Here we have plotted the Fibonacci retracement lines by clicking at the apparent Swing Low and moving the cursor to the potential Swing High. Note that the tool has automatically created the retracement levels between the top and bottom points.
In the next move shown below, you can observe that the price retraced back from the swing high (as expected), breached the 23.6 level, but eventually found support at the 38.2 Fibonacci zone.
Following a successful retest of the level, the price ascended in an upward price rally. Hence, placing a “long’ position at the 38.2 level would have been a lucrative trade opportunity here.
Drawing the Fibonacci levels for a bearish trade entry
In a downward-trending market, you can plot the Fibonacci levels by clicking on the most recent Swing High and dragging the cursor to 🡪 Swing Low.
In the US30 Chart below, you can see that the retracement levels have been drawn from the apparent Swing High to the Swing Low point. The aim is to identify a resistance level where the price may revert to its initial downward movement after retracing, offering a “sell” trade opportunity.
The next move is shown in the following chart. Note that the price briefly retested the 23.6 level but went all the way up to the 61.8 Fibonacci before actually continuing in its original direction.
In this case, if you had placed orders at the 61.8 level, you could have made a significant profit on that trade.
However, remember that the price will NOT always respect these levels. Even if it does, it is not possible to know exactly at which Fibonacci zone the price will reverse. Therefore, it is best to view the retracement levels as only the “possible” areas of interest rather than certainties.
Trading strategy – Combining Fibonacci retracement with trend lines
Supplementing the Fibonacci trading technique with a trend line analysis method can help to improve the effectiveness of your trades.
There are some instances when the Fib levels coincide with a potential trendline entry point, creating a confluence of trade signals.
For instance, observe that the price is respecting a bearish trendline in the XAU/USD 4-H chart below.
While you may consider entering a “sell” trade on the trendline bounce, what if you draw the Fibonacci retracements for getting a more optimal entry point? Upon plotting the zones, you can notice that the 38.2 and 50 levels may act as resistance because they are intersecting with the trendline.
Ultimately, the crossover of horizontal resistance (Fibonacci level – 50%) and the diagonal resistance (trend line) offered a high-quality trade opportunity in this case. In the following chart, you can see that the price rallied downwards after hitting the confluence point.
Trading strategy – Combining Fibonacci zones with support and resistance
Fibonacci retracements can also be conjoined with the support and resistance levels to enhance the quality of trades.
But how can it work? Let us look at an example.
In the GBP/USD, 1-D chart below, we have drawn the Fib zones for catching a bullish trade entry point on price retracement.
The next move in the following chart shows that the price indeed retraces to the 61.8 level and retests it.
Now, observe that this exact region – the 61.8% Fibonacci horizontal line – is also a key zone as per the price action. It was previously a resistance level, which has now turned into support. Simply put, two indications, one from the Fibonacci zone and the other from the pivot level, reinforces this trade setup.
Finally, the price successfully continues its bullish trajectory after bouncing from the retained level.
As discussed in the article, Fibonacci trading is a reliable way to catch the price moves at good entry points. However, it is an entirely subjective analysis method where every trader may consider different Swing High and Low points according to their own biases. So, overall, there is no single “right” way to determine retracement areas via the Fibonacci levels as it involves notable speculation. What traders can do is keep practicing with the tool and utilize it in combination with other indicators to scale up their probability of success.