How to Use Fibonacci Retracements?

A Fibonacci retracement is a key technical analysis tool that uses percentages and horizontal lines, drawn onto price charts, to identify possible areas of support and resistance. Identifying these areas is useful to traders since it can help them decide when to open and close a position, or when to apply stops and limits to their trades.

Why do traders use Fibonacci retracements?

Markets rarely move in a straight line and often experience temporary declines, known as pullbacks or retracements. Traders use Fibonacci retracements to gauge how far a market might reverse against its current trend.

These retracements are derived from the golden ratio, a mathematical concept. The Fibonacci sequence, which follows this ratio, begins 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, and continues, with each number approximately 1.618 times larger than the previous one.

To identify Fibonacci retracement levels, technical analysts plot six lines on a price chart. The key levels are 100% (the highest point), 0% (the lowest point), and 50% (the midpoint). Additional lines are drawn at 61.8%, 38.2%, and 23.6%, which correspond to significant Fibonacci ratios.

These levels are believed to indicate where support and resistance may occur, in line with the principles of the golden ratio.

Pros and cons of Fibonacci retracements

1. Pros of Fibonacci Retracements
Fibonacci retracements are useful for pinpointing levels of support and resistance, helping traders confirm market movements. These levels can suggest potential trends, indicating when it might be advantageous to enter or exit a position. When used effectively, Fibonacci retracements can offer valuable insights and enhance trading decisions.

2. Cons of Fibonacci Retracements
Despite their potential benefits, Fibonacci retracements require a solid understanding to be used effectively. Simply applying the Fibonacci percentages on a chart without proper analysis may not lead to successful outcomes. Novice traders should be cautious, ensuring that price dips are indeed temporary pullbacks rather than signs of a more enduring trend reversal.
Additionally, some traders argue that Fibonacci retracements can become a self-fulfilling prophecy. Since many traders use this tool, the resulting clustering of orders around key Fibonacci levels can influence the price, reinforcing the very levels they are designed to identify.

How to Use Fibonacci Retracements?

Traders in finance employ Fibonacci retracements to determine probable levels of support and resistance in the price movement of an asset.

1. Identify the High and Low Points: Determine the significant peak and trough of the asset’s price movement.

2. Plot the Fibonacci Retracement Levels: Use a charting tool to draw Fibonacci retracement levels between the identified high and low points. The key levels to include are 23.6%, 38.2%, 50%, 61.8%, and 100%, based on the Fibonacci sequence.

3. Assess Support and Resistance Levels: Watch for price action around these Fibonacci levels, as they may act as support or resistance during retracements.

4. Make Trading Decisions: If the price breaks through a support or resistance level, consider entering or exiting a trade based on this movement.

When considering shares, indices, forex (foreign exchange) and commodities for trading and price predictions, remember that trading CFDs involves a significant degree of risk and could result in capital loss.

Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be construed to be investment advice.