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Fibonacci retracements are a popular trading tool among chartists. In certain phases, traders can use them to forecast certain price movements. Here you learn step by step how to do it.
Fibonacci Retracements originate from 14th century mathematics.
The Fibonacci sequence is one of the best known formulas in mathematics. Each number in the sequence is the sum of the two numbers that precede it. Pay attention to this:
0, 1, 1, 1, 2, 3, 5, 8, 13, 21, 34 and so on. The mathematical equation it describes is Xn+2= Xn+1+1 + Xn.
The curious thing is that we encounter the Fibonacci sequence daily, especially in art and nature.
Yes I know you want to understand the connection between the Fibonacci sequence and stock market trading. That’s exactly what we’re looking at.
How is the Fibonacci retracement used in trading?
The Fibonacci Retracement method can be used in trading with amazing precision to predict price movements. It is a classic instrument of chart technique.
One of the pioneers of the chart technique was Ralph Nelson Elliott. For Elliott, stock markets run in waves, similar to the natural tides in the sea. A stock market boom is therefore equivalent to the tide that is eventually replaced by the ebb tide (bear market).
Elliott used Fibonacci’s sequence of numbers to forecast the extent of the ebb (i.e. the price correction).
He divided the distance between the high and low points of a movement according to the rules of the golden section.
As a result, three important markers emerged that are of great significance. In addition to 38.2%, there are both 50% and 61.8%.
Keep these marks in mind!
Because exactly these marks are important resistance and support zones in the chart technique.
It is partly already frightening, how exactly the course turns at these marks.
Where do I find the Fibonacci retracement and how do I apply it?
Generally, we use this tool to determine the end of a correction.
What was a correction again?
It is the countermovement to a long movement within a trend.
In the picture we see first a downward trend. This consists of downward movements (blue) and correction movements (pink). Since it is a downward trend, the downward movements are longer than the short intermediate corrections.
As always, a trend is over at some point and a trend change occurs (here green arrow). Now, long upward-movements follow with short intermediate corrections.
Some traders have missed the entry into the uptrend and still want to enter the market somehow.
The questions that a trader asks himself again and again are
- “Do I wait and risk the trend continuing without me?”
- “Has this movement ended and is a correction following?”
- “Yes, it is a correction, but where might it end so that I can make a good start?”
To make a better decision for or against a trade, traders use various tools. These can be technical or fundamental indicators.
The Fibonacci retracement is a technical indicator and helps us determine the possible end of a correction movement.
Above we have seen a long upward movement. Now the question is, where do I find the tool?
If you work with the Metatrader, you can find it in the menu under “Insert” -> “Fibonacci” -> “Retracement levels”.
When do I use the Fibonacci retracement in the chart?
We already know:
After a long upward movement, there are always corrective moves.
With the help of the Fibonacci Retracement, we now want to anticipate how far the correction could go or where it will end, and where it is worthwhile to enter the trend.
So if we see that a long upward (or downward) movement is coming to a halt and a top (or bottom) is forming, then we can apply the Fibonacci tool to the entire stretch. The longer the distance, the better.
Then you click on the Fibonacci tool in your charting software and drag it from the low point to the high point with the mouse button held down.
The tool then automatically inserts the selected reset levels.
The 0% are at the end of the movement (here at the top), followed by 23.8%, 38.2%, 50.0%, 61.8% and the beginning of the movement (100%).
As mentioned above, we focus on the 38.2, 50.0 and 61.8 mark. There we can then bet on a rebound, in which we make a long entry. If it were a downtrend here, we would trade short accordingly.
In this case, we are looking for a long entry, since the trend is long and we are looking for a good opportunity to participate in the long wave.
In the picture you can see that the price has already reached the 38.2 level and has first completed a rebound. As it looks, however, this is not sustainable and the course goes down one more floor. Maybe up to the 50 level?
If we look at the three main trading styles (scalping, day trading, swing trading), the entry price can be the same for everyone. If you believe in an end to the correction and the resumption of the upward trend, place your Buy Limit Order and wait until the price reaches the level.
So the entry price can be the same for all trading styles. Traders set a rebound at the respective Fibonacci level.
Now the wheat is separated from the chaff.
The scalper only wants to take a short rebound of 5 or 10 pips or points and is then already done. He is not interested in whether the trend will really continue or end. He just wants to see a jolt in the order book and take advantage of this overweighting of buyers.
The daytrader wants to see more. He aligns his take profit for example at the last daily high and would like to take maybe 20-100 pips.
The swing trader is even more relaxed and wants to experience not only a return to the top, but a continuation of the trend beyond it.
And just as the take profit is chosen, the stop loss must of course be chosen on the other side. All in accordance with the position size.
As an example for a daytrade, the following picture serves. Here an upward movement was discovered. The price found its top and started the correction. Only then could the trader apply the Fibonacci tool and draw the reset levels.
He decided to enter at the 50.0 level, stop loss hedging below the 61.8 level and take profit at the last local high point.
Using this example, you have learned the simple yet precise way in which Fibonacci retracements work.
You can easily learn how to trade using this setup by looking at historical price movements and using your charting program to connect the highs and lows.
A few more tips on Fibonacci Retracements:
Always look at the current movement.
Combine the Fibos 38, 50 and 61 with a support level or a resistance level (see charts)
Use Fibos initially in larger time units from 1h chart
Fibos work well in higher time units because many market participants (including institutional investors) pay attention to these levels and place their orders accordingly.
Especially the 50.0 level is very popular among traders and speculators. The chance of a winning trade is increased if other indicators such as PivotPoints or resistance/support zones are within this target range.
Of course, downtrends can also be traded using the Fibonacci retracement. As mentioned above, this tool is used to find a re-entry into a trend.
What are Fibonacci Extensions?
We have covered the Fibonacci Retracement in detail. It is a standard measure for support and resistance values in the market. These values are calculated by analyzing the retracement levels between two high and low points (trend). The next question we need to ask ourselves as traders is, what happens if the price exceeds the Swing Points we use to calculate our Fibonacci values?
At what point do we want to close our position? Is there perhaps a different way than the method already presented of using the last local high points (or low points for short)?
This is where the Fibonacci Extensions come into play. Fibonacci Extensions offer price targets that go beyond a 100% return of a previous move. The levels for Fibonacci extensions are calculated by taking the usual Fibonacci levels and adding them up to 100%. Therefore the extension levels for Fibonacci are as follows: 138.2%, 150%, 161.8%, 231.8%, 261.8%, 361.8% and 423.6%.
The 150 and 161.8 are the most important ones. Here is an example.
This tool can therefore be used to determine price targets.
You can select the respective levels individually in Metatrader 4 with a right click on the drawn Fibonacci retracement line.
Fibonacci retracements are of course not a universal weapon. They do not exist in trading. Here probabilities are traded and risk and money management are taken into account.
But Fibos offer you a good opportunity to trade a retracement after a correction has been made – both long and short!
You can easily test this instrument without any risk in backtests and papertrades and optimize your trading.
As a Forex Newstrader, it is a tool for me that can optimize my trade, but is never the sole reason for a long or short. Because here the trade idea always comes from fundamental analysis (economic data, news, etc.).