Fibonacci retracement levels can trigger great price moves
BY Chris Andreou
|June 4, 2021As we all know, the market first moves directionally and then retraces some of the earlier move before resuming its original trend again. This goes on and on in the markets. If we’d know beforehand how much a market retraces before starting the next directional move we’d be millionaires pretty quickly. Unfortunately, we don’t know the future and are forced to live with quite a bit of uncertainty. So what’s the next best thing to knowing exactly where the retracements could turn into a direction move again? This article provides you with a tool that helps in deciding the likely retracement in the price. It’s called the Fibonacci retracement tool and it can help you a lot if you know how to use it in combination with other significant technical factors. Interested? Read on!
We get some help in our trading from an unlikely source: a 13th-century mathematician called Leonardo of Pisa or Leonardo Bonacci. Most traders, however, know him as Leonardo Fibonacci. This remarkable man from the Republic of Pisa is considered to be the most talented western mathematician of the Middle Ages and the Fibonacci retracement tool is a modern application of his work.
As a young boy, Leonardo was familiarized with the Hindu Arabic numeral system and travelled the Mediterranean coast extensively. This allowed him to meet different merchants and he got to know the way they used arithmetic in running their businesses. This background allowed Fibonacci to develop into a brilliant mathematician.
He is best known for what is called the Fibonacci sequence. In this sequence, each number is the sum of the previous two numbers. The sequence was first posed and solved in a document that originated in India and was related to the growth of a population of rabbits. The solution was the sequence of numbers known as the Fibonacci sequence.
The sequence is quite simple as you can see from this example (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377). Each number is just the sum of the two previous numbers. We know that generational mechanisms in nature follow this principle. For instance, the volume of a new unit in some plants is the sum of the volume of the two previous units.
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Leonardo of Pisa also discovered that every number in the sequence is approximately 61.8% of the next number in the sequence. For instance, 55 / 89 results in 61.8% and so does 233 / 377. And, the same applies to 144 / 223. In fact, we could start at 21 divided by 34 and then keep on going out to infinity and we would always get a ratio of 0.618 (= 61.8%). The 61.8% retracement level is one of the most important Fibonacci retracement levels the traders use.
What about the other Fibonacci retracement levels? 55 / 144 gives us 38.2% and so does 21 / 55. Again 38.2 is one of the most used Fibonacci retracement levels when analysing the markets. Then there’s the 23.6% Fibonacci retracement level. This percentage value is derived by dividing a number in the sequence by another number that is two numbers later in the sequence. Take for instance 55, 89, 144, 233. If we divide 55 by 233 the result is 23.6%. 50% is not a Fibonacci ratio but it is still included in the Fibonacci retracement tool.
In this article, I will show you how these numbers can help us to identify key levels in the markets. After reading this article you will start to notice how more often than not critical price levels coincide with the Fibonacci numbers.
The correct way of using the Fibonacci retracement tool
When using the Fibonacci retracement tool we are looking to analyze how much the market has retraced from the latest peak. This is why we need to draw the lines from a prominent reactionary low to the latest reactionary high. Let’s take look at an example here.
Here I am using a prominent low as a starting point (blue arrow) and the latest high value (red arrow) to draw the Fibonacci retracement levels. This provides me with a set of horizontal lines (Fibonacci retracement levels) ranging from 23.6% to 61.8%. You can see on the chart how the EURUSD currency pair retraced almost to the 50% level but then the buying started right above the level and the pair rallied higher. The price then retraced back to 38.2 Fibonacci retracement level before bouncing higher. In this example, Fibonacci retracement levels are applied on 30 minutes chart. However, due to the fractal nature of the markets, the same analysis principles can be applied to any time frame. Just remember that the smaller the timeframe you analyse the more there will be false signals. Higher timeframe charts (weekly, daily, 8h and 4h) tend to be the most reliable timeframes for price action analysis.
Traders applying Fibonacci retracement levels to intraday charts need to remember that the moves they can expect are likely to be much smaller than the moves in the daily charts. This is because the ranges in the intraday charts are smaller. In other words, the support and resistance levels are closer.
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The chart above is a EURUSD daily chart and as you can see the same analysis principles can be applied here also. I am using a prominent low and the latest high to draw the levels. This will place the 23.6% Fibonacci retracement level to 1.2132. When the price retraced back to the level the traders started to buy EURUSD again thus giving us an opportunity to join the big money traders (remember: they move the markets!) and make money on the long side.
In uptrends, we look to buy at (or near) Fibonacci retracement levels and in downtrends, we look for sell opportunities as the price rallies and approaches the retracement levels.
Gold chart 2h
Let’s now take a look at how to combine different analysis methods with the Fibonacci retracement levels. I am using this method (quite successfully!) every day to find great trading ideas by identifying key support and resistance zones. The above chart is from my recent XAUUSD analysis. Here I identified the 1802 – 1810 resistance area as an important zone as the 38.2% Fibonacci retracement was inside the zone. In the same analysis, I also pointed out that the 1799.88 support level (a penetrated resistance level) was a key support level as the 23.6% Fibonacci retracement level roughly coincided with it. Let’s take a look at how relevant this analysis was.
Gold chart 30 min.
As you can see the rally inside the resistance zone I had identified but to be exact, the very top of this move was at 38.2% Fibonacci retracement level (the first red arrow). That’s where sellers came in with force and started to push the price lower.
Then price moved to my support level and penetrated it slightly before the buyers started to bid the price higher right at the 23.6% Fibonacci support level(!). The high at the 38.2% Fibonacci level became the day high on February 1st 2022. Then the market rallied giving our traders an opportunity to take pips from long trades. This rally started to fade just belowt the 38.2% Fibonacci retracement level.
Dax 2h chart
The above chart as you can see is from the TIOmarkets twitter feed. See how nicely the rising trendline and the 23.6% Fibonacci retracement levels coincided. On top of this we had a measured move projection pointing to the same price level. I was saying at the time that Dax could attract buyers there on a conditiona that the US indices didn’t collapse. As you can see from the next chart there was a lot of buying that started at the 23.6% retracement level.
Dax 2h chart
Dax traded right back to the level indicated by my analysis and that’s where the bulls really took over the market and started push the market higher. The resulting move was approximately 4% as measured at the time of writing this.
I’m sure you can see how relevant these levels can be when correctly combined with other technical tools.
Please remember that in order to make sure you are comfortable using this technical tool or approach you have to do your own research and see if you can rely on this idea. We do not suggest you will apply any strategy without a thorough backtesting or forward testing on your part.
Hope you found this article interesting and helpful. TIOmarkets is committed to helping you to learn and develop yourself as a trader. This is why we provide you with great market analysis and other education material at TIOmarkets.com/analysis. I share from my 20+ years of experience in markets and trading and help you to become a better trader. Also, if you haven’t yet done so, open a VIP Black account with TIOmarkets. You will get a great trading environment with tight spreads and no monthly subscription or per-trade fees.
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Janne Muta
Chief Market Analyst
TIOmarkets
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