Fibonacci retracement levels have long been a useful tool for foreign exchange (forex) traders who use technical analysis to generate trading signals. If you’ve ever wondered how to use the Fibonacci retracement tool in your currency trading analysis, Benzinga explains in this article how to apply Fibonacci retracements to forex charts. The article also reveals how currency traders can apply the Fibonacci ratios to find optimum trade entry and exit levels.
What Is the Fibonacci Retracement?
Mathematician Leonardo Pisano Bigollo, aka Leonardo Fibonacci, first introduced the Fibonacci number sequence to Western Europe in his “Book of the Abacus” in 1202 to answer a problem regarding reproduction in a theoretical population of rabbits. The number sequence had been in use in India since 200 B.C., however, and Indian mathematician Acarya Virahanka further developed the sequence around 600 A.D.
The Fibonacci number sequence is the basis for the ratios or percentages used in the Fibonacci retracement levels that many technical forex traders use. It begins with 0 and 1, and it then progresses to infinity by adding the previous two numbers together to arrive at the following number in the series. The Fibonacci sequence appears as follows:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597…
Some interesting data about the ratio of numbers in the sequence drew the attention of market analysts in the early 20th century who discovered that market corrections or retracements could be traded using the Fibonacci ratios.
As a result, well-known technical analyst R.N. Elliott added Fibonacci retracement objectives to his Wave Theory tenets in the 1940s. Elliot’s Wave Theory was based on his careful observations of the nature of mass human psychology and its repetitious impact on markets that created a general tendency for prices to move in five-wave trends followed by either sharp three-wave corrections he called zig-zags or five-wave triangular consolidations.
Elliott attributed this repetitious wavelike nature of market movements in part to the mathematical importance of the Fibonacci sequence of numbers to natural processes where mass psychology had an impact. To obtain the ratios he used in his Elliott Wave Theory, the numbers in the series have to be divided among themselves.
Here's an Example
The ratio of one number in the Fibonacci series when divided by the next comes close to the so-called Golden Mean number of 0.618. Also, the ratio of one sequenced number when divided by the number two steps higher approaches 0.382, while the ratio of one number divided by the number three steps higher comes close to 0.236.
In practice, Fibonacci retracement levels are represented on an exchange rate chart by a set of horizontal lines drawn between two market extremes at Fibonacci ratios of the distance between those extreme points. These levels indicate probable levels of support in case an uptrend is being retraced downward or resistance if a downtrend is retracing upward.
Each of the Fibonacci retracement levels is associated with a specific percentage related to how much of a previous move the asset has retraced or might retrace in the future. The specific percentage retracement levels of 23.6%, 38.2% and 61.8% are the original Fibonacci ratio percentages, but most technical traders using the Fibonacci ratios also add the 0:1 or 0%, 1:2 or 50% and 1:1 or 100% ratios because they also relate to the Fibonacci sequence.
A persistent controversy has arisen among technical analysts as to what level should fill in the rather large gap between the 61.8% and 100% retracement levels. Some analysts take the difference between 100% and 23.6% to yield 76.4%, while others prefer the square root of 61.8% or 78.6%. Some analysts use both numbers in the absence of a general consensus about the best percentage to use.
Therefore, the complete set of Fibonacci ratios derived from the numbers sequence commonly used for Fib retracement analysis by technical analysts are:
0%, 23.6%, 38.2%, 50%, 61.8%, 76.4% and/or 78.6% and 100%
By noting where the retracement levels corresponding to these ratios occur after a significant rally or decline in an exchange rate, technical forex traders can position themselves appropriately in the market. The following sections will discuss how technical forex traders use Fibonacci retracement levels in practice.
How Does Fibonacci Retracement Work?
In revising his Wave Theory, Elliott proposed using the aforementioned Fibonacci percentages of a preceding directional market move to trade market corrections as a set of retracement objectives.
Elliott also theorized that if a Fibonacci retracement level gives way during a market correction, breaking either the computed lines of resistance or support, then the market should proceed to the next Fibonacci retracement level as a new target for the ongoing correction to meet.
If the important 61.8% Fibonacci retracement level gives way, Elliott noted that a correction will usually fully retrace to the initial level of the move to result in a full correction of 100%.
Alternatively, if the market comes back to levels between the correction’s initial level and the 23.6% retracement level, then Elliott’s theory suggests the correction is probably over and a new trending move in the same direction as the previous move would be likely to occur.
In practice, technical analysts typically use Fibonacci retracements when a trend in the market begins to show signs of a retracement or correction in the opposite direction from the initial trending move. They would compute the Fibonacci percentages of the length of the preceding trending move to produce a series of retracement objectives for the pending correction.
Fibonacci ratios can be drawn between any two extreme chart points, such as a trough and a peak or a peak and a trough. This gives you the flexibility of being able to use the Fibonacci retracement levels in markets that are correcting higher or lower.
What Do Fibonacci Retracements Indicate?
Fibonacci retracement levels can provide forex traders with helpful objectives they can use as indicators when taking and exiting positions. The most common way to use Fibonacci retracement levels when trading is to compute them when the market starts to retrace a significant move and draw them on your chart.
You can then watch closely for the market to penetrate them. Once a particular level has been broken, the next retracement level becomes the subsequent target level.
Most importantly, when the key 61.8% Fibo level breaks during a correction, the correction often takes the exchange rate back to the start of the preceding trend.
If that critical Fibonacci level does break, traders will usually position in the direction of the correction. They also typically place their stop-loss orders on the other side of the 61.8% level in case the market reverses unexpectedly.
Drawbacks of Using Fibonacci Retracement Levels
Even useful technical analysis methods like Fibonacci retracement levels have their drawbacks.
For example, inexperienced forex traders who improperly compute retracement levels or do not implement the standard retracement trading methods correctly can experience disastrous results.
Additional common issues novice or uneducated traders experience include making poor entry and exit point choices and adding to a losing position rather than closing it out promptly. Another mistake often made by traders using Fibonacci retracement levels is using the wrong reference points when computing the retracements.
To avoid this drawback, you should aim to keep your reference points consistent when calculating Fibonacci retracement levels. For example, if you wish to compute the retracement levels of a recent uptrend, you can use a pair of exchange rates that are absolute extremes, closing or mid rates, but you should avoid using a mixture of those rates when calculating Fibonacci retracement levels.
You’ll also want to avoid having a nearsighted approach when using Fibonacci retracement levels without keeping the overall market direction and momentum firmly in mind. Although this analysis method works in both short and long time frames, keep in mind the old saying that “the trend is your friend” when trading currency pairs.
Another potential drawback is that Fibonacci retracements are best used with confirmation from another technical indicator, so avoid relying solely on them in your trading strategy. Many traders prefer to get confirmation from a second indicator because using only one indicator might give false signals that can result in unprofitable trades.
For example, you can complement your Fibonacci retracement analysis with a momentum indicator like the moving average convergence divergence (MACD), the relative strength index (RSI) or the stochastic oscillator. Such indicators can help you assess the strength of a market move, which can significantly increase your chances of making profitable trades.
How to Find Fibonacci Retracement Levels
You can definitely calculate Fibonacci retracement levels by hand, although most decent charting software and forex trading platforms provide a set of ready-to-use Fibonacci retracement levels you can easily apply to exchange rate charts displayed on your computer’s screen.
If you intend to use such software to generate Fibonacci levels for a particular market move, you would most likely need to indicate the beginning and the end of the move to your software program to get an accurate calculation of the Fibonacci retracement levels for that move.
Uptrend
Consider a scenario where the AUD/USD exchange rate has trended higher from 0.6000 to 0.7000. If a corrective down move retraces 23.6% of its length or:
0.7000-0.6000 = 0.1000 * 23.6% = 0.0236 = 236 pips
or more, then the exchange rate has retreated from its 0.7000 high point to one 236 pips lower, or a rate of:
0.7000 - 0.0236 = 0.6764
Once AUD/USD’s exchange rate falls and stays below that 23.6% retracement level at 0.6764, you can reasonably expect that it will continue to decline correctively toward the next 38.2% Fibonacci retracement level of 0.6618.
You can then take a short position in the AUD/USD pair to profit from the corrective decline and place a stop-loss order safely above the 23.6% retracement level. Profits could be taken on the short just ahead of the 38.2% Fibonacci retracement level, but if that breaks, then you could expect a move to the 61.8% retracement level.
This method could be followed through successive retracement percentages as the rate continued correcting lower until the market eventually reversed, moving higher and resuming its upward trend. The signal for this reversal would be a sustained break above the 23.6% level at 0.6764
Downtrend
Consider a scenario where the AUD/USD exchange rate has trended lower from 0.7000 to 0.6000. After the initial move corrects over 23.6% of its length or:
0.7000-0.6000 = 0.1000 * 23.6% = 0.0236 = 236 pips
This move would imply that the exchange rate has rallied 236 pips from its 0.6000 low point to a rate of:
0.6000 + 0.0236 = 0.6236
A currency trader using Fib retracement levels could then reasonably expect that the exchange rate will continue to rally correctively as long as the market remains above the 23.6% level at 0.6236.
They could establish a long position in the AUD/USD pair to take advantage of the upside correction and place the appropriate stops below this 23.6% level. Profits could then be taken just ahead of each Fibonacci retracement level in the sequence, starting with the 38.2% Fibo level at 0.6382.
This method could be followed through successive retracement percentages as the rate continued correcting higher until the market eventually reversed, moving lower and resuming its downward trend. The signal for this occurrence would be a sustained break below the 23.6% Fibo level at 0.6236.
Fibonacci Retracements vs. Fibonacci Extensions
Fibonacci projections or extensions are somewhat similar to Fibonacci retracements because both are part of Elliott Wave Theory and are regularly used by forex traders to come up with an exchange rate target during a market move.
The retracement levels are generally used to provide exchange rate targets during a correction. In contrast, Fibonacci projection levels are mainly computed by traders to help them determine the possible target levels of an ongoing upward or downward trend after a correction has taken place. This helps them know when to offload any trend-following positions they might have accumulated while the correction was taking place.
The percentages used in Fibonacci projections are also different from those used in Fibonacci retracements. The most important Fibonacci projection levels technical traders tend to watch are the 100%, 161.8%, 200% and 261.8% levels of the length of the first leg projected from the start of the third leg, although some traders also consider the 123.6%, 138.2% and 150% Fibonacci projection levels as possible targets.
Another significant difference between Fibonacci retracements and projections is the number of points required to compute them. Fibonacci projections are drawn by connecting three points while drawing Fibonacci Retracements requires just two points.
The three points required for a Fibonacci projection calculation are:
- The starting level of the trend that begins the first leg
- The level where the trend initially concluded at the end of the first leg and where the second leg begins that retraces the first leg
- The extreme level that marks the conclusion of the second leg and the start of the third leg that will move in the same direction as the first leg.
For example, the first rising leg of an uptrend is measured from the initial start of the trend (Point #1) up to the first swing high (Point #2). The second downward leg retraces part of the first leg and is measured from the first swing high down to the low point where the correction ends and a new upward move begins (Point #3).
Traders can then project their preferred Fibonacci percentages of the first leg that went from Point #1 to Point #2 upward from Point #3. They might use those projection levels as targets and aim to get out of long positions just before the market reaches them.
In a downtrend, the first down leg starts at Point #1, then the market falls to Point #2 before correcting higher to Point #3. Projections for the resuming downtrend using the Fibonacci percentages of the move from Point #1 to Point #2 are then made using Point #3 as the starting level.
Does it Make Sense to Use Fibonacci Retracements?
If you are a fundamental or news trader, you will probably not find Fibonacci retracements very helpful to your trading process because you may largely make your trading decisions based on factors other than technical analysis.
Those traders who use technical analysis and review exchange rate charts regularly will likely find Fibonacci retracements very useful. This market analysis method works in just about any time frame, and it helps traders set clear objectives during a market correction.
Furthermore, those traders who subscribe to and use the principles of Elliot Wave Theory to inform their trading activities will definitely want to consider using Fibonacci retracements levels as part of their overall trading strategy because Elliott strongly recommended doing so.
Frequently Asked Questions
Where do you start the Fibonacci retracement?
Fibonacci retracement levels are computed starting from a market extreme, such as a peak or trough.
Is Fibonacci retracement a good strategy?
Many technical traders consider Fibonacci retracements a good tool to help provide trading objectives during a market correction, so they follow Elliot’s advice by including Fibonacci retracement levels in their trading strategies.
What are the best Fibonacci levels?
The best Fibonacci retracement level to use when trading is the Golden Mean or 61.8% level, but the 23.6% and the 38.2% levels are also considered important by technical traders using this technique. The levels of 0%, 50%, 76.4% and/or 78.6% and 100% are considered less significant, but still potentially helpful, by many traders using this analysis method.