Fibonacci Retracements

A. What are Fibonacci Retracements?

Fibonacci Retracements
What are Fibonacci retracements?
Levels at which the market is expected to retrace to after a strong trend.
Based on mathematical numbers that repeat themselves in all walks of life, Fibonacci retracements attempt to measure the likely points that a currency pair will retrace, or pull back to within a range. The key numbers in FX trading are 38.2%, 50%, and 61.8%.
Consider the following example to see how Fibonacci retracements work:
Suppose an asset is on an uptrend, going from 0 and 1000. After the asset reaches 1,000, how far will it retrace – meaning how far will it fall – before resuming its initial uptrend? We can do this by using the Fibonacci retracement numbers to gauge how deep of a pullback we could expect after the top “boundary” is reached.
So, mathematically, it works like this:

• The 38.2% line. Calculate 38.2% of the size of the significant price move. The size of the significantprice move in this case is (1,000) minus the lower boundary (0). In this case, the size of the significantprice move is 1,000 pips. .382 x 1000 = 382 pips. It is expected that the asset will retrace 382 pointsfrom its peak. Assuming the asset is going up from 0 to 1,000, it would retrace 382 pips from 1,000.1,000 – 382 = 618. Accordingly, this is a key level to look out for; you may want to buy here (at 618), asit is expected the upward trend will resume after reaching this retracement level.
• The 50.0% line. Same situation; 50% of the significant price move (1,000 pips) is 500. Take that off from top (1,000) since it is an the upward trend. 1,000 – 500 = 500. Look for the upward trend to resume at that point.
• The 61.8% line. 61.8% of the significant price move is 618. 1,000 – 618 = 382. If the asset retraces to this point, it is viewed as an opportunity to buy.
  

If the asset were trending lower – meaning it had gone from 1,000 to 0 – then you would use the
Fibonacci numbers to calculate the retracement regarding how far the price may rise before resuming the downtrend again. You would calculate the Fibonacci retracements in the same manner, except you would draw from the high point of the significant price move to the low point of the move.

Parameters: 38.2%, 50.0%, and 61.8% are the most common Fibonacci Levels. The 38.2% level is considered the least significant of the three major Fibonacci levels. The larger the percentage line (i.e. 61.8%) the greater the likelihood that the price will find support.

Please keep in mind that other retracement levels exist in Fibonacci Studies that are not widely watched by the market. These levels include 21.4% and 78.6% as well as 127.2% and 161.8% extensions. Most charting packages do not even reference these levels and most traders would argue that if the market retraces 100% of a previous move, the original trend is no longer valid. Other Fibonacci studies called fans and arcs are quite mathematically complicated and are similarly ignored by most traders.

Key Concept: Look for Confirmation

• Traders should enter when confirmation - for example key candlestick patterns – emerge at Fibonacci levels. Traders can also seek confirmation from a variety of other indicators, as we will see as the course continues.

B. How to Draw Fibonacci Lines
Fibonacci Retracements: How to Draw Them

• Drawing Fibonacci lines is easy. It can be broken down into three easy steps:Identify the bottom and top of the overall trend. The bottom is referred to as support, and the top isreferred to as resistance. While they are subjective, support and resistance levels can easily bedetermined simply by looking at a chart.

• Using a charting package you are comfortable with, draw Fibonacci lines from the support level to the resistance level. The three lines should appear: one at 38.2% of the difference from the top and the bottom; one at 50%; and another at 61.8%. These are the key Fibonacci levels around which you should look for potential opportunities to enter trades.

• After that, simply look for price action to confirm an opportunity to enter a trade.

C. Fibonacci Retracements: Historical Trades
Below are two examples of how Fibonacci retracements, when used in conjunction with candlestick patterns, can be useful indicators for suggesting when a trend will reverse itself. Note how Fibonacci retracements work in both bullish (upwards trending) and bearish (downwards trending) markets.

Look at a Poor Fibonacci Trade
In order to learn how best to use Fibonacci retracements when trading the FX market, it is worth examining examples of traders often use them poorly.
The following example shows how being over eager can cause a trader to enter the market without justification.
In the chart below, see that price comes very close to touching the fib level (by 13 pips) but does not quite break it. While many traders may take that as a positive sign (they may rationalize that the level was so strong that traders did not wait for it to touch the fib level), you ideally want to see the level being breached. The reason for it is because breakout traders may come into the market, thinking that price will go lower, maybe even down to a lower fib level. When the market reverses and starts to go back into the trend, these short traders will now have to eventually cover their trades at a loss. Short traders who need to cover their positions will add to the buying pressure, thereby increasing the probability of your trade going in your favor.