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In this post, we will discuss the Fibonacci retracement levels and how to use them as a part of your trading strategy.
What are the Fibonacci retracement levels
The Fibonacci retracement levels are predefined percentages that can be used in trading to identify potential support and resistance levels. The levels are 23.6%, 38.2%, 50%, 61.8% and 78.6%. Note that the 50% is not a mathematical fibonacci retracement level, however it is often used alongside the indicator in most trading platforms.
Even though the indicator is called the Fibonacci retracement (potential retracement or drop levels), the indicator mark significant levels where price action might experience either support or resistance.
The levels can be used on any chart time frame and for any duration by drawing the indicator from the bottom of the price levels to the top. The top of the indicator is the 0%, marking a 0% retracement. The bottom of the indicator should mark the 100% level, indicating a 100% retracement. Once you have selected the top and the bottom levels, the Fibonaccia retracement levels should be visible between the 0% and 100% levels. Take a look at the following chart as an example.
In the chart, we choose the daily time frame and for the selected time period from ~ 18th of September till 21st of October, we marked the top and bottom price levels of the price of gold. The indicator then marked our fib retracement levels for us.
Why are the Fibonacci retracement levels significant
Many mathematicians find the Fibonacci retracement levels significant as the Fibonacci rations can be observed throughout nature.
The origin of the retracement levels come from the Fibonacci sequence. The sequence is an infinite sequence of numbers that can be calculated by summing up the two numbers on the left. The sequence starts with 0 and 1 and continues on for ever:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 …..
The percentage levels can then be found out by selecting a number in the sequence and dividing the first number on the left side, the 2nd number, the 3rd, and so on by that number.
Take the number 89 for example. If we divide 55 by 89 we get 61.8%. Dividing 34 by 89, we get 38.2%. And so on. The 78.6% level comes from the square root of 61.8.
In trading, we find that the prices often experience either support or resistance at these levels. This happens due to two reasons:
- Let us be honest here, there are many retracement levels, and depending on the top and bottom of the indicator levels, you are bound to hit one of the retracement levels eventually.
- Trader and market psychology. It often happens that traders would like to take profits at a retracement level on purpose or unconsciously. It is also possible that traders find an asset under valued at one of those levels and trigger a bounce.
Fibonacci retracement levels as support and resistance
As mentioned previously, the Fibonacci retracement levels can act as both support and resistance. This gives us a hint to predict a price fall or a bounce up. Let us explore some examples.
In the previous chart, we display the price of the Apple stock. Here, we used the daily time chart. In order to predict future support and resistance levels, we used the top and bottom of the candles on the left hand-side to mark the Fibonacci retracement levels. On the right hand-side we observe that the levels acted as both support at the 50% level and resistance at the 0% (previous top).
Another example is the next chart showing the price of Bitcoin.
Notice in the chart how the retracement levels are acting as support and resistance. Note that we do not need to exactly hit the price line in order to experience support and resistance.
Fibonacci retracement levels trading strategies
Now that we know how significant the retracement levels are, you might be wondering, how do we know if a specific retracement level is going to act as support or resistance? Well, just like anything in trading, you never know for sure, but you can improve your odds.
Let us discuss a few important strategies that we could use to take advantage of the Fibonacci retracement levels in trading.
Combine retracement levels with RSI
One strategy that could be useful is to combine the retracement levels with the RSI to identify market entry and exit points. Take for example the following chart.
On the hourly chart above, we can see that when combining an upcoming Fibonacci retracement level with a local RSI top or bottom generates a reliable indicator for selling or buying.
Trade choppy markets using the Fibonacci retracement levels
Unlike moving averages, the Fibonacci retracement levels can be used to trade choppy markets. Choppy markets, or markets that are moving sideways are characterized by lack of trends. These markets move sideways within a specific range for a certain amount of time.
In the chart above, we can see that the market is choppy as the price is not trading above or below the 21 candle EMA. It keeps changing its place.Here, we can take advantage of the Fibonacci levels by selling and buying at the marked levels.
However, please note that trading choppy markets is extremely risky. It is also worthy to note that like any indicator, you should not use the Fibonacci retracement levels alone!. It is always wise to combine multiple signals from different indicators to increase the probability of success of the trade.
Using the retracement levels to decide stop loss / exit price points
Stop loss orders are one of the most important tactics to use to avoid a big loss when markets move in a direction that is not expected. However, it is often difficult to decide where to put the stop loss.
If you put it too high, you risk being knocked out of the market too soon due to small fluctuations. And if you put it too high, you will increase your loss.
The Fibonacci retracement levels can provide a nice guideline for placing stop losses. This is due to a few reasons:
- The retracement levels act as support lines. If we break them, then there is a high probability that we move much lower.
- If a retracement level is broken, it is more than likely that we will test the next retracement level.
The following chart highlights some possible entry and exit points.
In the chart above, we marked with the green arrows hypothetical entry points. The Fibonacci levels have been drawn from past tops and bottoms. Assuming that we enter a long position somewhere between two retracement levels, then you can mark your stop loss a little bit below the next retracement level. This is to allow the market to bounce up without being knocked out.
If the price moves lower than your stop loss, then your sell order is triggered to avoid moving further down with the market to the next retracement level. When the market reaches the next retracement level, it is then up to you to decide if you would like to buy back or not, depending on market indicators and conditions. However, at that point you have minimized your losses.
Please note that the same strategy can be applied when taking short positions.
In this post, we discussed how to use the Fibonacci retracement levels to help us determine support and resistance levels. We also discussed some trading strategies in which the indicator can be useful.
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