What Is Fibonacci Retracement? How Does It Work?

Forex market rarely moves in a straight line, and often experience temporary dips – known as pullbacks or retracements. The word “retracement” is often found in the context of Fibonacci retracements, which is used by forex traders to pinpoint where to place orders for market entry, taking profits and stop-loss orders.

Every foreign exchange trader will use Fibonacci retracements at some point in their trading career. But no matter how often you use this tool, what's most important is you use it correctly every time. In this article, we will tell you what is the Fibonacci Retracement and how to use it.

What Is Fibonacci Retracement

Retracement is a broader, more general topic, and quite often people referring to retracements are not referring to Fibonacci levels at all. Retracements are temporary price reversals that take place within a larger trend. The key here is that these price reversals are temporary and do not indicate a change in the larger trend.

Fibonacci retracements are retracements which occur at Fibonacci levels. Leonardo Fibonacci, an Italian mathematician from Pisa introduced an influential sequence of figures which have come to be known as the Fibonacci numbers. The Fibonacci sequence is a sequence of numbers where, after 0 and 1, every number is the sum of the two previous numbers.

What is significant about this pattern, however, is that the ratio of any number to the next one in the sequence tends to be 0.618. Furthermore, the ratio of any number to the number two places ahead in the sequence is always 0.382. Similarly, the ratio of any number to the number three places ahead tends to be 0.236. These ratios are commonly known as Fibonacci ratios.

Fibonacci retracement is a key technical analysis tool that uses percentages and horizontal lines, drawn onto price charts, to identify possible areas of support and resistance. Identifying these areas is useful to traders since it can help them decide when to open and close a position, or when to apply stops and limits to their trades.

How to Use Fibonacci Retracement

Fibonacci levels are mainly used to identify support and resistance levels. When a security is trending up or down, it usually pulls back slightly before continuing the trend. Often, it will retrace to a key Fibonacci retracement level such as 38.2% or 61.8%. These levels provide signals for traders to enter new positions in the direction of the original trend.

In An Upward Trend

There are three steps to draw Fibonacci retracement levels in an upward trend. The first step is identifying the direction of the market is uptrend. The second is attaching the Fibonacci retracement tool on the bottom and drag it to the right, all the way to the top. And the last step is monitoring the potential support levels.

In the chart above, the Fibonacci retracement levels are plotted using the Swing Low at 1.16897 and the Swing High at 1.17502. The retracement levels are 1.1735922 (26.3%), 1.1727089 (38.2%), 1.171995 (50%) and 1.1712811 (61.8%).

In the example above, the EUR/USD enjoyed a bullish trend before it began to retrace and move lower after reaching the high at 1.17502. With retracement during an uptrend, the expectation is that if EUR/USD retraces from this recent high at 1.17502, it will find support at one of the Fibonacci retracement levels where it will reverse up from.

In A Downward Trend

Similarly, there are also three steps to draw Fibonacci retracement levels in a downward trend. The first step is identifying the direction of the market is downward. The second is attaching the Fibonacci retracement tool on the top and drag it to the right, all the way to the bottom. And the last step is monitoring the potential resistance levels.

In the chart above, the Fibonacci retracement levels are plotted using the Swing Low at 1.17236 and the Swing High at 1.22664. The retracement levels are 1.180609 (26.3%), 1.1894055 (38.2%), 1.196515 (50%) and 1.2036245 (61.8%).

The expectation during a downtrend is that if the price retraces from its Swing Low, it could possibly encounter resistance at one of the Fibonacci levels as traders are waiting to sell at these levels.

3 Mistakes to Avoid When Using Fibonacci Retracement

Here are three mistakes that traders should avoid while trading with Fibonacci:

1. Mix Reference Points

When fitting Fibonacci retracements to price action, it's always good to keep your reference points consistent. This means one should take Fibonacci reference points from candle body to candle body and from shadow to shadow. The wrong reference points lead to incorrect analysis.

2. Ignore Long-Term Trends

New traders often try to measure significant moves and pullbacks in the short term without keeping the bigger picture in mind. This narrow perspective makes short-term trades more than a bit misguided.

Try as much to check the long-term trends as this will guide you in the right direction of momentum in which you should apply Fibonacci retracements.

3. Use Fibonacci Alone

The other common mistake that you should avoid comes in when you rely on Fibonacci retracement alone. Fibonacci is a reliable trade setup but one should not trade without confirmation by other technical indicators.

Applying additional technical tools like MACD or stochastic oscillators will support the trade opportunity and increase the likelihood of a good trade.

Conclusion

A lot of traders use Fibonacci retracement to identify potential support and resistance levels on a price chart which suggests reversal is likely. But additional support from other indicators, chart patterns, candlestick patterns and fundamentals are essential to formulate a better overall strategy. Follow the simple rules of applying Fibonacci retracements and learn from these common mistakes to help you analyze profitable opportunities in the currency markets.