What is Fibonacci retracement and how does it work?

2022-09-15, 02:22

[TL; DR]

🔹 The fibonacci retracement tool helps traders to spot reversal points and profit targets.

🔹 The fibonacci series include 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, and 377, among others.

🔹 0%; 23.6%; 38.2%; 61.8%; 78.6% and 100% are the key fibonacci ratios.

🔹 Using Fibonacci levels, traders can identify trade entry and exit points.

Introduction

The art of predicting future price movements determines the success or failure of any trader whether dealing with cryptocurrencies or forex. To achieve the goal of trading profitably, traders should use various technical tools, including indicators such as Bollinger Bands, Ichimoku Clouds, Relative Strength Index (RSI), Stochastic RSI Moving Averages and fibonacci retracement. In this article we discuss the Fibonacci retracement tool.

What is Fibonacci Retracement?

The fibonacci retracement tool is based on the discovery the Italian mathematician, Leonardo de Pisa, made 700 years ago. As a fact, the fibonacci retracement tool helps traders to determine turning or reversal points on a trading chart. In turn, this enables traders to enter or exit trades profitably .

The traders do so by using fibonacci retracement levels based on the established ratios generated from a sequence of figures called the fibonacci series.

Fibonacci series

The fibonacci series is a sequence of numbers, where the sum of any two consecutives figures gives us the next number. This series is long, although it starts with 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, and 377. The list continues. Let's look at some examples. 1 plus 2 gives us three. 2 plus 3 gives us 5 and so on.

There is one fascinating characteristic of this sequence. If you divide any number in this series by the one before it you get 1.618. This number is called the golden ratio and is applicable in various science fields such as engineering. Let’s have a few examples:
8/7 = 1.618
144/233= 1.618
89/55= 1.618

Other properties of the Fibonacci series
The other characteristic of the fibonacci series is that if you divide a number by a figure which is number two higher than it, you get the same digits, 0.382. For example:
34/89 = 0.382
89/233 = 0.382

Thirdly, if you divide any number by the figure which is three digits higher than it you get the same answer, 0.236
21/89 = 0.236
55/233 = 0.236

These numbers, 0.236; 0.382 and 1.618 are very important when we are using the fibonacci retracement tool for trading purposes. Notably, we can express the same numbers as percentages such as 23.6%, 38.2% and 161.8% as indicated in the diagram below.

Source: Scanz

Fibonacci retracement ratios

There are several ways in which we can calculate ratios or percentages from the sequence. Some of the important ratios are 0%; 23.6%; 38.2%; 61.8%; 78.6% and 100%.

However, there are other significant ratios such as 50%; 161.8% and 261.8%. Although we cannot get 50% through any calculations, it is important because it represents the midpoint between 0% and 100%.

It is also worth noting that 61.8% is an inverse of 1.618%. We also use it when making trading decisions. In other words, we divide any number by the next figure to get 0.618 (rounded to three decimal numbers). As an example, 21/34 = 0.6176, translating to 0.618, if we round it to three decimal numbers.

Therefore, the four ratios we derive from the Fibonacci sequence, 23.6%; 38.2%, 61.8% and 78.6% form key fibonacci retracement levels. As a result, there are four zones where the price downward trend corrections can stop and reverse. Generally, these are hidden support and resistance levels. When we draw horizontal lines along these points we get fibonacci retracement levels.

How to use fibonacci retracement in trading

Having discussed the above, let’s focus on how to use the fibonacci retracement tool when making trading decisions. As we said, the fibonacci retracement tool helps traders to identify potential reversal points. We use the fibonacci tool during upward or downward price trends. We cannot use it with a range market.

The first thing a trader should do is to draw the fibonacci retracement lines which act as dynamic support and resistance levels. Traders use support and resistance zones to determine trade entry and exit areas. They can also use these levels to establish profit targets and stop-loss points.

For example, depending on the price actions of the assets, a trader can buy a cryptocurrency when the price is at 38.2% retracement level and sell it when it reaches 23.6% level.

How to draw fibonacci retracement lines

First, the trader should identify the major swing highs and swing lows. During an uptrend, simply click on the swing low and drag the cursor to the swing high. The opposite is true for an upward trend. The trader should click on the swing high and drag the cursor to the swing low. The following chart illustrates that.

Source: Babypips

Once you do this, the charting tool will place in the various retracement lines. In this case, the levels are 7955 (23.6%), .7764 (38.2%), .7609 (50.0 %), .7454 (61.8%), and .7263 (76.4%).

The following example is what happens when there is a swing low.

Source: Babypips

In this case, the price bounced back through 23.6% and 38.2%. However, it did not continue below the 38.2% level. Now, the point is that you can base your trading decisions on these levels.

Fibonacci extension

A trader can also base his/her actions on the fibonacci extension. The extensions are the levels which traders use to establish potential profit targets following certain price trends. This is because every trader can choose a potential profit target which is outside the existing range.

As you can see, the main extension levels are 138.6%, 150%, and 161.8% 261.8% and 423.6%. Therefore, a trader can use both the fibonacci retracement lines and extension levels to make trading decisions.

Conclusion

Fibonacci retracement is a technical analysis tool traders use to predict potential price movements. In short, a trader can go long at a position along a fibonacci dynamic support level and sell at a suitable dynamic resistance level. Like any trading indicators, a trader should combine fibonacci retracement with other trading tools.

Author: Mashell C., Gate.io Researcher
This article represents only the views of the researcher and does not constitute any investment suggestions.
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