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Use Fibonacci Retracements to Find Trading Entry Points

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The Fibonacci Retracement tool, available in most trading platforms, can be used to find entry point areas when trading. Fibonacci Retracements can be used in any liquid forex pair, stock or futures contract, helping to establish where retracements/pullbacks may end, and the trend resumes. Throughout nature we see a repeating pattern, based on a series of numbers which Leonardo Pisano Bogollo (13th century) introduced to the West. The number series, and the Golden Ratio, are found in galaxy formations, plant growth and man-made structures. These “Fibonacci levels” are also found in financial markets, and can help us determine where the market may go. No indicator should be used in isolation, but by combining it with trend analysis (so you are taking trades in the right direction) it helps highlight logical areas for entering trades.

Fibonacci Numbers and Fibonacci Retracement Levels

When the price of an asset pulls back, that pullback typically has a mathematical relationship to the price wave that preceded it. This relationship is based on the “Golden Ratio” and a series of “Fibonacci Numbers” which help define the numerical relationship of one thing to another.

As a quick introduction, the following are Fibonacci numbers:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34…

The next number in the sequence is the sum of the prior two numbers before it. So the third number is 1, because the prior two numbers–added together–are 0 and 1. The 5 is a result of adding 2 and 3. 34 is  result of adding 13 and 21. The sequence continues indefinitely.

The “Golden Ratio” is derived from this sequence. As the sequence progresses, if a number is divided by the prior number it produces a ratio. 3/2 is 1.5, 13/8 is 1.625. As the numbers progress the relationship (ratio) reaches the Golden Ratio, 1.618. Since the number shows the relationship between an infinite amount of numbers (once the sequence gets going), it also tends to appear throughout nature.

Common Fibonacci Retracements levels are 23.6%, 38.2%, 50.0%, 61.8% and 78.6% (or 76.4%; since these are so close, it doesn’t really matter which is used). With the exception of 50%, these percentages are derived from the Fibonacci sequence. A number divided by the next highest number gravitates toward 61.8% (0.6180) as the numbers increase. A number divided by a number two places ahead of it gravitates toward 38.2% (0.3820), and a number divided by a number three places ahead of it gravitates toward 23.6% (0.2360). 76.4% is the result of subtracting 0.236 from 1.

50% isn’t really a Fibonacci retracement level, but is based on other technical analysis theories which state a pullback will often retrace about half of the prior advance. Since this does seem to hold true, 50% is often included when discussing Fibonacci retracement levels.

Most often these numbers are rounded off for actual trading, since they only provide an estimate of where the retracement is likely to go.

Think of these number this way. If the USD/JPY moves 100 pips higher, from 101 to 102 then a 23.6% retracement means the price pulls back (about) 24 pips, to 101.76. A 50% retracement means the price pulls back half of the prior advance–since the original advance was from 101 to 102, a 50% retracement of that brings the price back to 101.50.

Fibonacci retracements are most accurate on popular and highly liquid currency pairs, stocks and futures contracts. A low volume market is more swayed by individuals (and not a large group of traders) and therefore may have erratic movements which don’t align with the Fibonacci retracement levels.

Using the Fibonacci Retracement Tool

The Fibonacci Retracement tool is drawn over one price wave to provide a context for how far the pullback that follows it will go, before the trend (impulse direction) resumes again.

To apply the Fibonacci Retracement tool to your chart, select it in your trading platform (in MetaTrader: Insert  Fibonacci Retracement, or simply click on the icon on the toolbar). 

For an uptrend or impulse wave higher, put the 0.0 at the wave high and the 100 at the wave low. 

For a downtrend, or impulse wave lower, put the 100 at the top of the wave and the 0.0 at the bottom. This will provide you with the potential retracements for the pullback following the impulse wave.

The Fibonacci Retracement tool is applied to a EUR/USD daily chart in Figure 1.
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Figure 1. EURUSD Daily Chart with Fibonacci Retrecement Levels

Figure 1 shows the Fibonacci Retracement tool applied a price move higher (100 at low and 0 at high). The tool then provides areas where the pullback is likely to stall (later, which level(s) have the highest probability of causing the reversal will be discussed). In this case, the price stalls at the 61.8 level, and then resumes moving higher.

Once a new wave forms, you can delete the old Fibonacci retracement tools to avoid cluttering the chart. Although, you can use multiple Fibonacci Retracement levels on different time frames and on different scales (big moves and/or little moves on the same time frame) to keep track of where longer-term or short-term moves may go.

Interpreting Fibonacci Retracements

Once an impulse wave has occurred, and the tool has been applied to it, the price will quite often move to and stall at one of Fibonacci Retracement levels. If the price falls through one level it will likely proceed to the next level. Occasionally, a price may stall at one level, then proceed to the next, stall and proceed to the next and so on. During such times it is important to have some guidelines on which levels are likely to be most important in certain market conditions (this will require a lot of practice reading price action).

In a very strong trend, expect shallow pullbacks, to 23.6, 38.2 and sometimes 50. In “normal” trends, or during the middle of a trend expect a pullback to the 50 or 61.8 levels. Early in the trend (figure 1), late in the trend or during weak trends expect retracements/pullbacks to reach the 61.8 or 78.6 levels.

We can’t know in advance which Fibonacci level will stall the pullback, but by looking at the tendency of the price action and how strong price movements are, the above guide can help isolate where the pullback is likely going.

Fibonacci Retracement are a guide; don’t expect the price to stop exactly at a level. In figure 1 for example the price slighly over-shoots the 61.8 level. It is typical for the price to stall just above or below a Fibo level.

Figure 2 shows the tool applied to consecutive waves on a EURUSD Daily chart.
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Figure 2. EURUSD Daily Chart with Multiple Fibonacci Retracements
In figure 2 the tool has been applied to each major impulse wave higher.

Figure 3 shows the Fibonacci retracement tool applied to the entire move higher in figure 2. The most recent pullback comes very close to the 38.2 level before moving higher again.
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Figure 3. Fibonacci Tool Applied to Broad Trending Move (EURUSD Daily)

While daily charts have been used in these examples, the Fibonacci Retracements can be applied to any time frame, including ticks charts, 1-minute charts or weekly charts. Retracement levels can also be used on any liquid market, and applied to individual price waves or multiple price waves (for a broader perspective, like in figure 3).

Basic Fibonacci Retracement Strategy

In an uptrend, buy when the price pulls back and stalls near one of the Fibonacci retracement levels, and then begins to move back to the upside. Place a stop loss just below the price low that was just created, or below the next Fibonacci retracement level to give a bit more room.

In a downtrend sell when the price pulls up and stalls near one of the Fibonacci retracement levels, and then begins to move back to the downside. Place a stop loss just above the price high that was just created, or above the next Fibonacci retracement level to give a bit more room.

Looking at how strong the trend is can help determine which Fibonacci levels are most likely to stall and hopefully reverse the pullback. Recall:

In a very strong trend, expect shallow pullbacks, to 23.6, 38.2 and sometimes 50. In “normal” trends, or during the middle of a trend expect a pullback to the 50 or 61.8 levels. Early in the trend (figure 1), late in the trend or during weak trends expect retracements/pullbacks to reach the 61.8 or 78.6 levels.

This is only a guide though, determining what levels are most likely to hold will require a lot of study in regards to price action and tendency.

On the left half of Figure 4, the AUDUSD experienced an aggressive rally after a long downtrend. Due to the aggressive nature of the rally a shallower pullback was expected, likely to the 23.6 or 38.2 level. Figure 4 shows how the pullback unfolded. At first it stalled at the 23.6 level, but then fell through and proceeded to the 38.6 level where the pullback stopped and another move higher ensued. Entering long near the 38.2 level (once the price started moving higher off of it; see Day Trading Forex in Two Hours or Less for how to do this – the method applies to all markets, not just forex) with a stop loss just below the recent low is one potential way to use Fibonacci Retracements for finding entry points. Using an additional strategy to filter signals highly recommended.
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Figure 4. AUDUSD Fibonacci Retracement Trade Example
If the price retreats all the way to the 100% level, that means the entire prior move has been retraced, and shows a larger consolidation is occurring or the trend on the same degree as that wave is in jeopardy.

Problems with Fibonacci Retracements in Trading

The main problem with Fibonacci Retracements levels is that quite often the price won’t stop at an exact levels; it goes a little past or reverses before a level. With so many levels drawn–23.6%, 38.2%, 50.0%, 61.8% and 78.6% (or 76.4%)–and then also realizing the price doesn’t usually reverse right at a level, saying that Fibonacci Retracements pick exact reversal points may be a bit of wishful thinking.

If you trade often, you’ll learn that no matter how many perfect text books examples you see, when it comes to the real world, the price isn’t going to reverse exactly at a Fibonacci level much of the time. And when it does, we have multiple levels drawn, and have given them “leeway,” so a reversal right near a Fibonacci level could just be a fluke. Out of the thousands of price waves that occur in various markets each day, some are bound to reverse at one of those levels…or close to it. Many price waves are also bound to reverse right in between the levels, disregarding the levels altogether.There is also the issue of figuring out which Fibonacci retracement level is likely to halt and reverse a pullback.That said, I do still use Fibonacci Retracements….but in a less formal way….

How I Use Fibonacci Retracement Levels

I rarely use the Fibonacci Retracement tool on my charts. I know that I usually can’t pick the exact Fibonacci level the price will reverse at; and even if I get the level right the price may overshoot it or undershoot it. Therefore, I don’t draw the levels, and instead just estimate.

What I usually do is wait for retracements between 50% and 76.4%–estimated. Once the price enters that approximate area, I wait for a slowdown. A slow down is when the price moves sideways for a few bars during a pullback. The slow down is my trigger to get in (once the price moves out of the slowdown, back in the trending direction–see Day Trading Forex in Two Hours or Less for examples).

In this way I don’t end up trading all pullbacks, I only trade pullbacks that meet a certain criteria. This reduces the number of trades, and I avoid getting stopped out on shallow pullbacks that turn into deeper pullbacks (entering at 38.2%, and then price continues to move to the 61.8% level, resulting in a loss).

I am also taking into account that I usually can’t pick the exact reversal spot, even with the help of Fibonacci levels. So instead, I let the price tell me when it is ready to reverse. When the price pulls back into my possible trade zone, I just wait for the slowdown. If the slow down happens, and the price breaks back in the trending direction, I have a trade. No need for cluttering up the chart with levels which likely won’t given me any more information than I already have.

With my method I still have losing trades, but overall it works for me. Using Fibonacci Retracements isn’t required to trade successfully. Use them if they help you; if you find them of little value, never look at them again. Be sure to practice with them and test them out before incorporating them into your trading plan or using real capital.

Final Word on Fibonacci Retracements

Use the Fibonacci retracement tool on all time frames, from minute charts up to monthly. It is a trend following tool, and helps isolate where pullbacks may end and the trend resumes. Don’t place all your trust in it though. The price may not stop exactly at a Fibonacci level, rather it is just guide. Sometimes the price will completely disregard Fibonacci levels, often when major news occurs. Don’t try to force a tool to work if it isn’t working; you don’t need to use Fibonacci levels to trade successfully. Only use the Fibonacci retracement tool in conjunction with price analysis and as part of a complete trading plan.

Also use Fibonacci math to find profit targets, using the Fibonacci Expansion tool:
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