Fibonacci Retracement trading Strategy

Author: Consultant Finmaxfx

Fibonacci trading is a strategy based on determining several levels of a retracement depth. After a strong and sustainable trend, an asset price requires re-balancing of demand/supply ratio, buyers and sellers have to find an equilibrium, technical indicators have to reload the momentum, coming off overbought or oversold conditions. In other words, markets always move like waves and every single trend needs to regain power after correction in order to continue the price change in the same direction.

Forex traders can use both by-the-trend approaches when buying or selling an asset after the retracement is over or counter-trend reversal positioning in the market when prices breach a certain support or resistance level during corrections. Besides, the tool can also show the potential distance of the trend continuation and it is helpful in terms of finding perfect levels to take profits from previously opened deals. Indicators with Fibonacci levels are widely used in the technical analysis of any asset class and any timeframe. Daily and weekly technical outlooks traditionally contain an assessment of retracement levels when calculating support, resistance and possible reversal pivot points.

The analysis technique based on Fibonacci Retracement is a must-have tool in the arsenal of every Forex trader.

What is Fibonacci Retracement?

Fibonacci Retracement levels is a technical instrument used to measure the depth of a possible retracement, identify reversal pivot points, calculate resistance and support levels and show the trend’s direction. The indicator is used in the technical analysis on different timeframes as it takes into account any trend including long-term changes and short-term price fluctuations. This tool requires a basic trend to analyse so it does not work properly in sideways ranges when an asset price changes directions several times in a certain period. Before we dive deep into the usage of Fibonacci retracements in practical Forex trading, we should get to know the basics and mathematical background.

What is a Fibonacci row?

The Fibonacci row is a sequence of numbers where every next number is a simple sum of two previous ones.

Here is an example:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 and so on.

Some technical analysts use numbers from the Fibonacci row for indicators periods. Several currency pairs are vulnerable to the technical analysis with more accuracy when adjusting periods from round figures to numbers from the Fibonacci row. For example, moving average with period 55- instead of 50-days or 89- instead of 100-bars could show a better performance in terms of calculating retracements and showing support or resistance levels. Another option to increase the efficiency of Bollinger Bands indicator is to widen the period to 21-days or 34-bars instead of default 20 periods. Relative Strength Index could also be used with a period of 13 to increase the accuracy of trading signals.

What is the Golden Ratio?

But the main application of the sequence of numbers is in Fibo levels. Leonardo Fibonacci, an Italian mathematician, who lived in the 12th century, noticed that every next number of the row relates to the previous one with a fixed ratio of 1:1.618 or +61.8%. Many discoveries in a wide variety of sciences proved that this ratio is also used in different fields of science and even in nature. Thanks to that, the relation was called a Golden ratio. For example, the Golden ratio can be found in flower petals, animal and human bodies and even in DNA formations. Traders in the financial markets adopted the golden ratio to use it in the technical analysis. Technical analysts made the following conclusion while discovering price charts:

A trend is considered as sustainable until prices are above 61.8% of the basic uptrend counting from bottom to top.

From the main ratio, analysts also calculated several derivative ratios:

23.6%, 38.2%, 50%, 61.8%, 78.6% and 161.8%.

All of the levels are used in the Fibonacci retracement tool to indicate possible technical corrections.

How to use Fibonacci Retracement Levels?

Fibonacci trading suggests using the indicator to buy or sell an asset, which bounced off support or resistance level, offering attractive prices in accordance with the general trend. At the same time, Fibonacci levels can be applied to analyse pivot points on a larger timeframe but when the trading is made on a shorter chart period. Besides, the instrument can point to rates where the profit-taking is reasonable.

How to apply the Fibonacci Retracement levels on a price chart?

First of all, traders should find a sustainable and clear trend on a price chart. After that, analysts have to determine the top and the bottom of the trend. Typically, the technical analysis is aimed to consider close rates as prices for the top and the bottom of the trend. However, some cases suggest taking high rates for the top and lows for the bottom. We’ll use the first option for all of the examples here and beyond as most of the technical indicators have mathematical formulas which take into account close rates but not highs and lows.

Here is an example of how the Fibo Retracement levels look like:

How to use Fibonacci Retracement Levels

The price of gold was in a strong uptrend on the daily chart since the end of May 2019. The uptrend peaked on September 4. The Fibo levels take the lowest daily close rate ($1273.20) as the level of 0, and the highest daily close price ($1551.96) as the level of 1 (100%). This distance is the basic trend for the analysis. As a result, the indicator shows several levels of a possible retracement. According to the main rule mentioned above, the price of gold is technically still in the uptrend as daily rates are placed above the 61.8% Fibo retracement level ($1445.47), which acts as the nearest support as of the end of November.

If you like this strategy, you might also be interested in this Renko charts

Fibonacci Retracement Formula

The next question is how Fibonacci levels are calculated?

Let’s have an example with the same chart of gold as shown on the screenshot above:

  • Firstly - we need to figure out the length of the uptrend, which is calculated by simply subtracting the value at the level of 0 from the price at the top of the uptrend:

    $1551.96 - $1273.20 = $278.76

    The standard point of gold price for four-digit quotes in Forex is the first digit after the decimal point. So if a trader needs to calculate the number of pips, which the price of gold has moved during that uptrend, the value in U.S. dollar has to be multiplied by 10. In this case, we have got the result of 2787.6 pips;

  • Secondly - we need to calculate the price of gold where the Fibo retracement levels are placed. For example, if we take 61.8%, which is the main Fibo support level, we have to multiply it on the distance of the uptrend in U.S. dollars:

    $278.76 * 0.618 = $172.27

  • Thirdly - we have to add that amount with the price of gold at the beginning of the uptrend:

    $1273.20 + $172.27 = $1445.47

    The price chart confirms that 61.8% Fibo levels are placed exactly at the same level as we calculated.

Examples of profitable trading using Fibonacci Retracement levels

As already mentioned, the Fibonacci trading system works best in trending markets and the best application is in the long-term analysis as the most sustainable trends are represented on daily and weekly charts.

Here are several examples of how to trade in the Forex market using the Fibonacci levels.

Finding support levels for the S&P 500 benchmark during the uptrend

The weekly chart shows the S&P 500 index in the uptrend since February 2016. After the benchmark peaked in September 2018, a bearish correction started. Since the rate breached 78.6% Fibo support level in October 2018, a deeper retracement was expected. The stock index tested 50% Fibo support in December 2018 but failed to breach it with the weekly close price. In this case, the downside shadow on the weekly candlestick is ignored as it represents strong demand from equity investors. As a result, the benchmark reversed and continued the uptrend, breaking the value through several Fibo resistances, which confirmed strong bullish sentiment. The buying pressure continued when the index renewed its historical peak in April, July and November 2019.

Examples of profitable trading using Fibonacci Retracement levels

Buying GBP/USD on a bullish breakout of the Fibonacci resistance

The British pound was declining versus the U.S. dollar starting from April 2018 till August 2019. The weekly chart below has an obvious downtrend with several new bottoms charted. The initial upswing had a nature of a technical retracement as the bulls failed to lift GBP/USD above 78.6% Fibo resistance in September 2019 (see the red arrow on the screenshot below). As a result, the currency pair consolidated and even bounced back down in the next two weeks. However, the bulls regained the momentum and the exchange rate breached the resistance, accelerating the upside movement. The moment when GBP/USD breached the technical level was a perfect one to use the breakthrough trading strategy and open long positions. As of the end of November, the pair was consolidating around the next Fibonacci level - 61.8% - at around 1.2872.

Examples of profitable trading using Fibonacci Retracement levels

Finding Fibonacci Retracement Levels with other indicators

Fibonacci day trading is a profitable approach but it requires multi-level analysis on several timeframes. It’s hard to find a single technical indicator which could describe all of the processes happening in the financial markets and predict all of the price fluctuations. Therefore, technical analysts and forex traders use different combinations of technical indicators to empower their strengths and smooth weaknesses. Let’s have a look at several examples of how to use Fibonacci for trading together with other instruments.

Fibo levels and Ichimoku Cloud

Among powerful and efficient trend indicators, Ichimoku Cloud points to reversals and indicates retracement levels different from Fibonacci lines. The example below is a weekly chart of the price of WTI Crude oil, showing how these technical instruments work together. After the uptrend peaked and the bearish retracement started, the price of oil breached 78.6% Fibo support level, pointing to deeper retracement south. Ichimoku Cloud confirmed the signal as the weekly close rate appeared below both Ichimoku Conversion and Baseline, which used to act as support curves. Since then, the price of black gold plunged 12-week rally, breaching several support levels. After the 50%, Fibo was breached and the price of WTI Crude went out of the Ichimoku cloud, another sell-signal occurred. Further developments of the trend show how Ichimoku cloud might have trading signals even if a Fibo level was not achieved during the bullish retracement, which ended in April 2019.

Fibonacci Retracement trading Strategy

Fibonacci levels and MACD

Another strong trend indicator to use in combination with Fibo levels is MACD. In summer 2019, crypto traders and investors were wondering if the price of Bitcoin would continue its impressive rally, which started in spring. Fibonacci Retracement levels showed that BTC/USD peaked and began a bearish correction. However, the July’s drop of the price was limited be 61.8% Fibo levels (green arrow), which acted as a support level. MACD started lowering the negative surplus of the histogram, confirming that the bearish slide bottomed out. As a result of a sideways retracement, Bitcoin price breached the Fibo resistance again, however, the bullish rally failed to continue. MACD charted a bearish crossover on August 13 (red arrow), which was a strong sell-signal. Since then, Bitcoin is in a descending bearish channel.

Fibonacci Retracement trading Strategy

Conclusion

Fibonacci trading is a system based on determining long-term trends and finding support and resistance levels, which underline a possible depth of a retracement. The indicator is a powerful and effective trend tool, simple to use and understand. As long as the nature of some trends could be uncertain, and several signals require additional confirmation, Fibo levels are used in combinations with other trend indicators to increase the efficiency of a trading system, lower the number of fake breakouts and smooth market noise. Sometimes additional indicators could create a great addition to the system as the Fibo tool operates with ranges, while other indicators can point out an exact reversal level.

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