Fibonacci retracements are among the most popular trading tools based on the Fibonacci number sequence and ratios. They are used along with other techniques like Fibonacci extensions and arcs to identify potential support and resistance levels and reversal points in the market.
What are Fibonacci numbers?
The retracement levels are based on a sequence of numbers discovered by the mathematician Leonardo Bonacci.
The Fibonacci sequence starts with 0 and 1, and each subsequent number is the sum of the two previous numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, and so forth.
This pattern tends to commonly occur in nature. For example, when you cut open a seashell, each new chamber is equal to the size of the two before it, and in the case of flower heads, seeds originate from the centre and then spiral outwards, almost always equaling a Fibonacci number.
How are retracement levels calculated?
The Fibonacci trading tool generally draws seven horizontal lines on a price chart, which indicate where support or resistance may emerge after a strong trending move. These include the lowest, average, and highest points (0%, 50%, 100%) and other significant percentages derived from the Fibonacci sequence, including 23.6%, 38.2%, 61.8%, and 78.6%.
To utilise the trading tool, traders must identify the high and low points for a trend in the market for a given timeframe. The highest point reached before a downtrend or the lowest point reached before an uptrend indicates the 100% level. Conversely, the lowest point of a downtrend or the highest point of an uptrend represents the 0% level.
The levels are calculated by dividing the vertical distance of the overall move (100% to 0%) by the key Fibonacci ratios. In the example below, the market rallies 100 points, then pulls back. The 50% retracement level occurs at 150 USD. This is calculated by subtracting 50 (50% of the 100 point rally) from 200 (the highest point reached).
Where do retracement levels occur?
After a significant upward move, retracement levels can indicate potential support zones where the uptrend may resume. Conversely, after a strong downtrend, they can highlight resistance levels where selling may emerge again.
Market sentiment tends to determine the significance of each Fibonacci level. Strong retracements (23.6% to 38.2%) typically occur during confident market movements, and weaker retracements (61.8% to 76.4%) often take place during a period of hesitation.
The 50% level and 61.8% "golden ratio" tend to be key tests before reaching the 100% retracement level, which usually signals a primary trend reversal.
How to use Fibonacci retracements in trading
The trading tool can be found in Deriv MT5 under Insert > Fibonacci > Fibonacci Retracement, as seen below.
When you spot a strong trend, the tool can be used to highlight possible reversal points to assist with trade entry and exit planning.
The tool will indicate support levels during an uptrend and resistance levels during a downtrend. If the market respects a retracement level, it signals that traders are paying attention to that potential support or resistance.
While useful on their own, Fibonacci retracement levels are even more powerful when combined with other analysis techniques. Some ways traders can apply them include:
- With support/resistance - The Fibonacci levels can be used to confirm horizontal support and resistance levels identified through previous swing highs and lows. The confluence between the two increases credibility.
- With moving averages - Retracements to a moving average acting as dynamic support or resistance can signal high probability reversal points. The 50% level with a 50-day MA is a common combination.
- With candlestick patterns - Candlestick signals appearing near Fibonacci levels add further confirmation of possible trend reversals. For example, a bullish engulfing pattern at the 61.8% level.
- Across timeframes - Shorter time frames can provide entry points. Zooming out to longer time frames reveals the major Fibonacci levels other traders are watching. These can act as broader support and resistance.
- With indicators like RSI or stochastics - Oversold/overbought readings near retracement levels can indicate exhaustion selling/buying and impending reversals.
By applying the tool to different timeframes and combining these levels with other indicators, you can help to determine more careful entry and exit strategies and improve chances for more successful trades.
Try out the Fibonacci retracement on your forex CFD trades risk free with a free demo account that’s credited with 10,000 USD in virtual funds.
Disclaimer:
The information contained in this blog article is for educational purposes only and is not intended as financial or investment advice.
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