Trading with Fibonacci retracement

by | Feb 6, 2019 | Forex, Stocks/ETFs | 0 comments

Fibonacci retracement is a powerful tool to complement your trading strategy. It can be used in several markets, e.g., Stocks, ETFs, Forex. What is the idea behind Fibonacci, and how to use it in trading?

Let’s start with the basics. Fibonacci was an Italian mathematician, and he is famous for the so-called Fibonacci sequence. What is that? Simply stated, it is the sequence of numbers, starting from 1, 1, where each number of the sequence is equal to the sum of the previous two numbers. Hence, the sequence is 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 and so on.

What is so special about this sequence? When you progress with the sequence, the ratio between each number and the previous one will give you approximatively 1.618. This is called golden ratio, and it finds application in many fields.

Moreover, each number divided by the next one will give you approximatively 0.618. And each number divided by the one you find two places after it will give you around 0.382. Ok, this is interesting, but how is it related to trading?

As you may know, the price of an asset does not move as a straight line. Actually, there are phases of impulse and phases of retracement. For example, in an uptrend that is characterized by higher highs and higher lows, the impulse connects a low and the next high, whereas the retracement connects the high with the next low. In a downtrend, the opposite applies: the impulse connect a high with the next low, and the retracement connects the low with the next high. This is summarized in the next picture.

impulse and retracement

Impulse (Imp) and Retracement (ret) in uptrend and downtrend

The interesting thing is that often a retracement will extend for 38.2%, 50%, or 61.8% of the previous impulse width. Then, a new impulse will start.  Do you remember these values? Yes, they are the Fibonacci numbers (except 50%, that is used as a retracement level as well).

Why does this work? This may be an example of a self-fulfilling prophecy. This means that many people use these levels so they actually become real. In addition, if a retracement extends way above the 61.8% level the main trend may be over. However, bear in mind that this technique should not be used alone but as a complement to your trading strategy.

Probably the best way to understand how to use Fibonacci retracement is to see a real example. You can do it by watching the video below.