How to Use Fibonacci Retracement

Fibonacci retracement is a popular tool in technical analysis used by traders to identify potential reversal levels and support or resistance points in the price movement of assets. Based on the Fibonacci sequence, this tool applies specific ratios—such as 23.6%, 38.2%, 50%, 61.8%, and 78.6%—to help forecast areas where the price might experience a pullback or continuation in its trend.

By plotting Fibonacci retracement levels on a chart, traders can make informed decisions on entry and exit points, improving the chances of capitalizing on market fluctuations. Whether you're trading stocks, forex, or cryptocurrencies, understanding how to apply Fibonacci retracement can be a powerful addition to your technical analysis toolkit.

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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.

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

While Fibonacci retracement levels are a popular tool in technical analysis, they do have some limitations, especially for inexperienced traders.

1. Incorrect Calculation: Beginners may struggle with calculating retracement levels accurately. Errors in computing or applying the retracement method can lead to significant losses.
2. Poor Entry/Exit Decisions: Many novice traders make mistakes with entry and exit points. They may also add to a losing position instead of closing it promptly, leading to further losses.
3. Using Incorrect Reference Points: One common error is using inconsistent reference points for retracement calculations. To avoid this, use consistent points, such as extreme high and low exchange rates, closing rates, or mid-rates, but don’t mix them.
4. Nearsighted Trading: Traders often focus too narrowly on short-term retracements without considering the overall market trend. It’s important to keep the broader market direction and momentum in mind, as the saying goes, “the trend is your friend.”
5. Over-Reliance on Fibonacci: Relying solely on Fibonacci retracements can be risky. To reduce false signals, many traders use a second technical indicator, such as the moving average convergence divergence (MACD), the relative strength index (RSI), or the stochastic oscillator. These indicators can provide better insight into the strength of a market move, increasing the chances of 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.

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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: 

1. The starting level of the trend that begins the first leg
2. 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
3. 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. 

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