How to Use the Fibonacci Retracement Indicator Correctly
Fibonacci trading is a popular trading strategy across all the major financial markets – including stocks, futures, and forex. Investors and day traders have multiple ways to employ the Fibonacci ratios developed by the 13th-century Italian mathematician of the same name.
The most common form of Fibonacci trading uses what is known as the Fibonacci retracement levels. The Fibonacci retracement tool is a technical analysis indicator usually included with just about any charting or day trading software program that investors can access through their brokerage firm.
This article will show you how to use the Fibonacci retracement indicator to pinpoint potential market entry or exit points.
History of the Fibonacci Retracement Tool
The 13th-century mathematician we know as Fibonacci (even though that wasn’t actually his name) noted a particular number sequence with an intriguing relationship between the numbers. Each successive number in the Fibonacci number sequence is equal to the sum of the two previous numbers added together.
The numbers in the sequence are as follows:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89…(and continuing)
So, where did the Fibonacci retracement levels come from?
They were developed from a second relationship Fibonacci discovered, which existed between the Fibonacci numbers – a ratio relationship. Starting at the number 2, each following number in the Fibonacci sequence is equal to approximately the number preceding it multiplied by 1.618. Alternatively, multiplying any number in the sequence by 0.618 yields approximately the immediately preceding number.
Fibonacci crowned the 1.618 ratio as the “golden ratio” and went on to illustrate how it occurred over and over in the natural world, showing up in everything from plant biology to works of art.
It was the discoveries of the golden ratio’s occurrence in the “real world” that made people begin paying serious attention to Fibonacci numbers and ratios.
What are today known as the Fibonacci retracement levels were derived from further relationships between the numbers in the Fibonacci number sequence. The first is the ratio of 0.618, which happens to be the inverse of 1.618, Fibonacci’s golden ratio, which you get by dividing any number in the Fibonacci number sequence by the immediately following number. If you divide any number in the sequence by the second number that follows it, you get the ratio 0.382.
Dividing a Fibonacci sequence number by the third following number in the sequence, for example, 13 divided by 55, the result is the ratio 0.236.
The Fibonacci retracement levels, which are percentages, were created by multiplying the Fibonacci ratios by 100 (e.g., 0.618 x 100 = 61.8). You may have noticed that 61.8, in relation to the number 100, is the inverse of 38.2. The inverse of 23.6 in relation to 100 is 76.4. With that addition, we have all of the most commonly used Fibonacci retracement levels 23.6%, 38.2%, 61.8%, and 76.4%.
Using Fibonacci Retracements to Identify Support and Resistance
All right, so you’ve got four percentages that constitute the Fibonacci retracement levels. The next question is, how are those percentages and levels used in financial market trading?
Fibonacci retracements are a technical analysis tool. It is used to identify price levels that may provide support or resistance when a stock or other financial security experiences a corrective retracement in the opposite direction of the prevailing trend.
In other words, when a security’s overall trend is an uptrend, a corrective retracement downward may end when the market finds support around one of the Fibonacci retracement levels.
Thus, for example, a stock may find price support and turn back to the upside following a corrective retracement that represents a price decline of 38.2% of the distance between the most recent high price and the low price where the overall uptrend began.
In a bear market, where a downtrend is in control, corrective retracements to the upside may find resistance price levels at one of the Fibonacci levels that represent a 23.6%, 32.8%, 61.8%, or 76.4% retracement of the existing downtrend.
For example, a declining stock might retrace 61.8% of its move to the downside and then encounter sufficient price resistance to force a resumption of the controlling downtrend.
The Fibonacci Retracement Level That’s Not One of the Fibonacci Retracements
The Fibonacci technical indicator included with many charting programs often shows – in addition to the retracement levels of 23.6%, 38.2%, 61.8%, and 76.4% – the price level that represents a 50% corrective retracement of the prevailing market trend.
A 50% retracement is not actually a Fibonacci retracement, but many Fibonacci indicators mark that price level simply because a halfway retracement of an existing trend has, historically, frequently turned out to be a significant level of price support and resistance levels.
How to Use the Fibonacci Retracement Levels
Using the Fibonacci indicator tool is as easy as loading it onto a chart when you notice what appears to be a corrective retracement move in the price action of a financial security.
- First, select the Fibonacci indicator from your available technical indicators.
- Then, assuming that the prevailing overall trend is an uptrend, draw a line from the low (starting point) of the uptrend to the highest price (or highest closing price – whatever your preference is) of the uptrend.
The Fibonacci indicator will then automatically produce a series of horizontal lines that indicate each of the key Fibonacci retracement levels on the chart. Each retracement level represents a price point where the market may find support and resume the overall uptrend. Thus, those price points may be used as low-risk market entry points to buy stock in hopes of it going higher if and when the uptrend is resumed.
When you have the Fibonacci retracement price levels clearly marked on your chart, the next step in Fibonacci trading is to watch the price action that occurs around those price levels.
Look for Confirmation of Support
You’re looking for signs of price support forming at one or the other of the Fibonacci levels. Such confirmation can be a candlestick pattern or a specific volume profile. Suppose the price does appear to find support. In that case, an investor can buy into the market with relatively low risk because they can run a stop-loss order just a bit below the Fibonacci retracement level where the security appears to find support.
For example, suppose a stock price of $50 coincided with a 38.2% retracement of an uptrend, and the stock seemed to find price support there, not moving significantly lower. In that case, an investor might purchase the stock and run a stop-loss order at $47, thus risking only a $3 per share loss.
To increase the probability of entering a trade at a desirable price level, most investors don’t use Fibonacci levels in isolation. Instead, they combine the Fibonacci indicator with other technical indicators, such as momentum indicators or key moving averages, to get a clearer indication of price support/resistance.
Example of Using The Fibonacci Indicator
Let’s see an example of a Fibonacci trading strategy in action. The daily chart of Apple Inc. (NASDAQ: AAPL) below shows the Fibonacci retracement tool in action. The Fibonacci lines are drawn when a corrective retracement to the downside begins in late December 2020, during an overall uptrend that began in at the beginning of June 2019.
Apple stock indeed finds price support right around the 61.8% retracement level, from where it resumes an uptrend. The 61.8% Fibonacci level proved to be an excellent buy entry point for acquiring Apple stock.
An Additional Use of the Fibonacci Indicator
The Fibonacci indicator is primarily used to identify potential support and resistance market entry price levels. However, it can also be employed to set profit targets once an investment has been made. Fibonacci percentage levels above the previous high in an uptrend (or below the previous low in a prevailing downtrend) represent potential profit targets.
Those price levels would be pinpointed with lines showing the prices equal to 123%, 138%, 161%, and 176% of the distance between the beginning low of the uptrend and the high price reached prior to the corrective downside retracement. From the lows in March 2020, it formed higher highs and higher lows, leading to a high above $130 per share with a gain of +139.21% over a period of 5 months.
Fibonacci Indicator Summary
The key Fibonacci ratios that comprise the Fibonacci retracement lines offer investors a means of identifying potentially advantageous market entry points. They represent support and resistance levels.
As a result, investors can consider buying or selling a stock or other financial security with relatively limited risk if appropriately combined with other price action confirmations. The Fibonacci trading tool is included with most charting software precisely because it’s a technical indicator that investors widely use in virtually every financial trading market.
See Also: Best Day Trading Indicators