What is Fibonacci Retracement?
The Fibonacci Retracement is a forex strategy that pinpoints potential levels at which the price moves back to the direction of the trend after a pullback. It uses the concept of Fibonacci or the sequence of numbers that are coordinated with numbers previous to it, following a ratio that indefinitely makes a pattern. In Fibonacci, each succeeding number is the sum of its two preceding numbers.
This concept is applied to the Fibonacci Retracement, wherein an attempt to read the market, traders pinpoint particular levels at which a bounce from a pullback is set to happen.
How to use Fibonacci Retracement Levels
The Fibonacci Retracement has four predetermined levels, namely: 23.6, 38.2, 61.8, and 76.4. Most often, level 50.0 is also considered, despite not being part of the Fibonacci sequence. The idea behind it is that each number in the mathematical sequence is roughly 61.8% of the number that succeeds it, then roughly 38.2% of the number that follows, and roughly 23.6% of the number subsequent to that. The final retracement level, which is at 76.4, was taken from subtracting 23.6 from 100. In the price chart, these numbers pertain to the percentage of retraction from a significant price point used as a reference.
Reading Market Psychology with Fibonacci Retracement
Analysts believe that the Fibonacci sequence not only appears in nature but is rather also prevalent in human behavior. They believe that the Fibonacci sequence can appear in market psychology as a natural response and attempt to counter the prevailing market sentiment, hence the pullback from the existing trend.
Fibonacci retracement levels are not only used as price points that traders wait for a bounce to happen. Other than being used as a basis for possible retraction points, they can also be used when setting stop loss and take profit and placing entry points. These retracement levels are also often likened to support and resistance levels.
Trading with Fibonacci Retracement Levels
To know how to draw Fibonacci Retracement levels on your trading chart, you must first choose two price points: one high and one low point. Drag your cursor from this one point to the other. Automatically, the Fibonacci Retracement levels will show on your chart, allowing you to use it as a reference in your trading decisions.
See photo below:
Fibonacci Retracement on Uptrend
During an uptrend, it is best to open a long position at a Fibonacci retracement level in hopes that it will hold and push the price back to the direction of the trend.
The market will most likely attempt to break an ongoing uptrend before it breaks resistance, so a retracement is possible. Once it happens, traders will pinpoint to any of the Fibonacci retracement levels, open a buy position, and wait for the bounce to happen.
Fibonacci Retracement on Downtrend
On a downtrend, it is best to open a short position at a Fibonacci retracement level and wait for the price to stall at this level and move back to the trend’s direction.
In an attempt to break the current downtrend, as is the proposed market psychology of Fibonacci retracement, traders will avoid a resistance breakout, so retraction is a possibility. Once retraction takes place, traders will then refer to any Fibonacci retracement level, open a sell position, and wait for the price to bounce back to the direction of the trend.
It is best to use the Fibonacci retracement with other indicators to get a stronger reading of the price action. Use the Fibonacci retracement with caution, as retractions are not always guaranteed. Remember that the forex market is very volatile and that no indicator can fully predict the price movement.