Last Updated on June 13, 2022
The concept of Fibonacci retracements is straightforward. It’s a technical indicator that adds horizontal lines to your chart to indicate notable support and resistance levels. You can use them on any index, futures chart, currency exchange chart, etc. Many traders consider the Fibonacci retracements a reliable source of buy/sell signals. Said signals are based on various gradual retracements between the swing low and swing high points. Many traders believe in these signals so much that they often end up becoming a self-fulfilling prophecy. Meanwhile, other traders will use the Fibonacci retracements together with other forms of technical analysis. In this article, we’ll take a closer look at the Fibonacci retracement tool.
What are Fibonacci Retracements?
Let’s start with a brief bit of history. Going by the name, you would think that Fibonacci was some famous Italian artist or musician. In reality, he was neither. He was actually a mathematician born in 1170. His original name was Leonardo of Pisa. He only earned the name Fibonacci post-mortem, often credited to historian Guillaume Libri. The name was a portmanteau of filius Bonacci, meaning son of Bonacci.
It is fair to say that Fibonacci’s numbers theory attracts a great deal of controversy among traders. The ones who advocate for it argue that these numbers are spontaneously replicate in nature, architecture, and many other areas of life. This suggests that the patterns they form have an inherent meaning. We can apply them to trading as well. The typical counter-argument is that this is simply a function of mob psychology. When enough traders believe these numbers to be meaningful, that can shift the entire market if they act on it simultaneously.
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The Fibonacci Sequence
The actual Fibonacci sequence is 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 and so on. Basically, each new number is the sum of the two previous numbers. So how do these numbers give us the Fibonacci retracement levels? As the sequence goes on, each number gets closer and closer to 61.8% of the next number. That’s how you get the first retracement level: 55/89 = 61.8%. The second level is any number divided by the second number to the right. For example, 34/89 = 38.2%. The third level is dividing by the third number to the right, i.e., 21/89 = 23.6%.
Going by that logic, dividing 1 by 1 gives you 100%, and 1 by 2 is 50%. That makes 100% and 50% relative retracement levels as well. When you line the numbers up, you’ll see an almost symmetrical sequence. However, something is missing.
| 23.6% |
| 38.2% |
| 50% |
| 61.8% |
| 100% |
To make it completely symmetrical, we’ll need to add one more retracement level. Subtract 23.6% from 100% to get our final retracement level at 76.4%. The final sequence should look like this:
| 23.6% |
| 38.2% |
| 50% |
| 61.8% |
| 76.4% |
| 100% |
Now that the sequence is complete, it’s time to ask whether these percentages have any real value. Whether you’re looking at the shape of a snail’s shell, flower petals, the leaves or branches of trees, or even the reproductive pattern of rabbits, you will find the Fibonacci sequence repeating time and time again. Given that it’s so commonplace, why not try applying it to trading?
How do Fibonacci Retracements Work?
We have added the various Fibonacci retracement lines to the chart below. As you will see shortly, there is a method to this madness. The idea is simple: on the way down, the Fibonacci retracement lines act as support lines. Conversely, on the way up, they are a form of resistance. Let us say, for example, that price was to crash through support at the 23.6% retracement line. The next powerful line of support will be at the 38.2% retracement line. Then, it is 50% until full retracement back to the original swing low level. As you will see with the E-Mini S&P 500 Index chart, the trendline support keeps growing. Instead, it falls. What we end up seeing is the trend getting increasingly stronger.
There will obviously be occasions where a fall is temporary and merely a rebalancing of bears and bulls. This is similar to when you pour additional water into a container and the surface ripples until it calms down. This is a natural mixture of different investors. On the one hand, you have those taking their profits from investments at the lower levels. On the other, there are those looking to jump on board the uptrend but still waiting for a short-term retracement. Many traders will also use the various Fibonacci retracement levels as stop-loss limits or a means of protecting profits. Typically the trend does seem to be changing.
How to Calculate Fibonacci Retracements?
Let’s use the chart above as our basis for analyzing the Fibonacci retracement tool. As you will see from looking at it, it is all based around the swing low and the swing high. In the example above, the swing low for the E-Mini S&P 500 index is 3126.25. The swing high is 3169.25. Both of these figures are shown in the white boxes. The retracement factors for the Fibonacci theory are as follows:-
- 23.6%
- 38.2%
- 61.8%
- 76.4%
If we take the difference between the swing high and the swing low (3169.25-3126.25), we get a gap of 43. This is when we turn to our trusty spreadsheet to do the calculations for us. So let’s simply apply the retracement lines from earlier to the chart above. That’ll give us the following numbers:
- 3159.00
- 3152.50
- 3142.50
- 3136.25
At this point, we can recognize that the graph is starting to get a little crowded. Even so, many traders will still add an additional trendline at 50%. In this example, it is 3147.75. It all looks very technical, but what exactly does it mean? Should we be buying at the trendline or selling at the trendline? Maybe monitor its price until others dictate the direction? This is where the whole concept of the Fibonacci retracement theory is challenged.
How to Use Fibonacci Retracements
The E-Mini S&P 500 Index graph perfectly illustrates how to use Fibonacci retracement to enhance your trading strategies. It is worth noting that although many traders use Fibonacci levels to consider their next move, they won’t stop there. They may also take into account the longer-term trends. These can, in some cases, strengthen the argument for using Fibonacci retracements. So, let’s look at how traders may have done well during the above period of relative volatility.
Applying it in Practice
In this case, you can see the swing low level at 3126.25. Then, the swing high at 3169.25. This gives us our actual range of 43. When the index hits the short-term high, we immediately calculate the various Fibonacci retracement levels. Interestingly, there is strong support at the 23.6% retracement level. That leads to a relatively tight trading range in the early days after the high. You can see occasions where the index dipped below this support level. However, it then bounced back from the 38.2% retracement trendline. So far, so good.
A relatively short period of stagnation between the first/second trendlines and then suddenly turned into an uptrend. The index burst through the 23.6% retracement level (initially a support line), which was now a resistance. What many would describe as a period of consolidation then turned into a resumption of the previous uptrend. Where would it end? It is fascinating to see that once a peak of 3169.25 had been met, there was a limited appetite to push the index into new territory. The index started to turn downwards, the trend was changing, and it quickly began to crash through support levels. There was a limited degree of support between the first and second Fibonacci retracement levels. Even so, it was a powerful downtrend. We could see the index crashing through one support level after another.
The Full Retracement
While not as uncommon as many people might assume, we saw a full retracement back to and even below the previous swing low level (100% retracement). The fundamentals had obviously changed, and investors were running for the hills. The reason being that there was minimal support on the way down. Even after crashing through the 100% retracement level. Take a look at the right of the chart. You will eventually see a partial recovery. We can observe strong evidence of the Fibonacci retracement levels proving to be both resistance and support. Fascinating stuff!
How to Use Fibonacci Retracements With Price Action
Incorporating Fibonacci retracement levels with price action has been extremely lucrative for many traders. In simple terms, investors will first focus very closely on the Fibonacci retracement levels. Then, they’ll incorporate their own opinion. In many cases, this is based on historical price movements, resistance, and support. No matter how technical your trading strategy gets, it’s difficult to completely avoid getting your ego involved.
There are many factors to consider when using price action. Especially when analyzing the many trends, we see repeated time and time again. One of the more common trends revolves around the 50% retracement level, which can occur for several reasons:
- The index is simply overbought
- Profit takers gain control dragging the index down
- Over exuberance
- Buyers take control at the 50% retracement level
Many of you will be reading this passage with a degree of skepticism. Maybe even downright disbelief. If you still have your doubts, let’s take a look at the next chart:
The 50% Retracement
Let’s take a look at the point where the index bounced. It happened at the 50% retracement between the initial swing low at 3035.25 and the swing high at 3074.75. Moving towards new higher levels, the swing high very quickly became a support level. The whole concept of the Fibonacci retracement theory is based upon a maintained trend. If you see an index moving higher very quickly, there is a good chance you will see natural retracement at some point. However, the trend might still be intact. As we mentioned above, human nature suggests those with large paper profits will look to protect these profits. On the other hand, those who missed out on the initial uptrend may feel that the 50% retracement gives them the perfect buying opportunity. They don’t want to miss out again, and in this case, that’s the correct choice.
Have you ever wondered how many other traders are waiting to buy the same price level that you are? Let us say, for example, in the case of a 50% retracement from a relatively short-term spike in any asset/contract. Just look at the case above. Once the 50% retracement was complete, the bulls took over, and there was a relatively short sharp upturn. It was a deluge of buying orders, pent-up demand, or whatever else you like to call it. The point is, the rebound from this support level was robust. It did not just continue the initial uptrend, either. Tt was actually strengthened once the profit-takers had been shaken out.
How to Use Fibonacci Retracements With Long-Term Trendlines
There are numerous ways to incorporate the Fibonacci retracement theory with other types of technical/chart analysis. The use of a long-term trendline with various Fibonacci retracement levels can create powerful signals. As you’ll see below, in this scenario, it is a sell signal.
As you can see, we have plotted a trendline from the swing low-level crossing the 23.6% Fibonacci retracement level. At this point, it was evident that the support line was about to break. The uptrend that began at the swing low was also at risk due to the sudden market downturn. This led to a 76.4% retracement. Then, a degree of support until this failed, and we saw a 100% retracement of the rise.
If you’re still a skeptic, you could point out that we are proving a point in hindsight. Even so, it is plain to see that the uptrend was over when the index crashed through the initial support level and the long-term trendline. You could argue back and forth about whether these lines are viable when trading in real-time. Even so, there’s one thing worth keeping in mind. The majority of traders will have their eyes on both the Fibonacci retracement levels and long-term trends.
Is this a self-fulfilling prophecy or simply a case of history repeating itself, you decide.
Pros and Cons of The Fibonacci Retracement Tool
There are many different aspects to take into consideration when looking at the Fibonacci retracement theory. Such as:-
Does the theory work?
As much as people argue for or against the Fibonacci theory, the fact is, it does repeatedly appear in nature. This is undeniable. Whether the pattern can be translated into asset valuation trends, investment strategies, and, more importantly, human nature is debatable. Are we merely making use of the oldest trend strategy in the world? Or is the support for it amongst traders so intense that it determines the trend itself. In the end, if it helps you make a profit or reduce losses, does it really matter?
Timing is the key
Are you one step ahead of the crowd, knowing that other traders are waiting for the support/resistance level to be breached? Or do you wait until a firm trend has emerged? This is where additional factors, such as long-term trendlines and price action strategies, come into play. They can confirm or undermine the basic Fibonacci retracement level argument.
Selling too soon
In the words of JPMorgan:
“I made a fortune getting out too soon”
What does this mean, and how can you use it? Riding an uptrend is relatively easy in theory. There may be ups and downs and fluctuations, but if the trend remains intact, then run your winners. However, what happens if you sell on the first retracement once it crashes through the 23.6% Fibonacci retracement level? Well, the worst-case scenario is you bank a profit, and you live to fight another day. The best-case scenario is that the breakthrough was an actual change in the trend. That means the 23.6% support line was a precursor to further weakness.
While we mentioned the natural 50% retracement, there is no guarantee that the index will bounce back towards its previous highs. Indeed, the previous 23.6% support line may turn into strong resistance.
How The Fibonacci Retracement Tool Can Help You
Even reading through the theory behind the Fibonacci retracement tool will give you an idea of natural trends. It’s also evident that a large number of traders do take this particular investment strategy into account. You could even argue that as a result of that, it becomes a self-fulfilling prophecy. Even so, it should still be included in your arsenal of trading tools.
The least charitable view is that the Fibonacci traders are nothing more than sheep following the herd. Even so, there’s value in knowing which way the herd is going. Therefore, it makes sense to incorporate at least an element of the Fibonacci theory into your investment strategy. If the support lines are indicating breakout or a fall-through resistance, this might attract your attention. However, what if long-term trend lines have also been broken? You now have two robust indicators suggesting that the trend is changing. There could be a breakout on the upside, or there could be a significant downside in the short term. You can now invest with a little more confidence.
Like so many investment strategies, making the Fibonacci retracement principle work requires you to stick rigidly to the fundamentals.
F.A.Q.
The Fibonacci retracement theory is a great way of highlighting support/resistance lines on a currency/index chart. Any move through these support/resistance lines can indicate, at worst, a short-term change in the trend and, at best, from a trader’s perspective, a fundamental change in the trend. Either way, there may be the option to trade the trend.
The most common Fibonacci ratios are 23.6%, 38.2%, 61.8%, and then we have the inclusion of 76.4% and what many see as a natural retracement level 50%. We know how these figures are calculated. We know where they come from and that gives a degree of confidence. Whether they are relevant and dictate price movements or simply a self-fulfilling prophecy, if you can ride the trend and get out at the right time, haven’t they served their purpose?
Whether looking at futures, indices, stocks and shares, currencies, or any asset/investment with a spot price, the Fibonacci retracement principle is a valid consideration. The fact that the whole principle is based upon nature and the replication of the underlying calculations shows the versatility of the theory.
There are two fascinating concepts in the Fibonacci retracement theory, the natural 50% retracement of a spike in the value of an index/currency/futures contract and an indication that an uptrend is emerging. Incorporating additional trends, fundamentals, and good old-fashioned gut feeling can also help. However, many would argue that the fundamentals are already in the index/contract price, and all you need to focus on is trends repeating themselves and gut feeling.
The reality is that no chart analysis strategy is perfect, which applies to the Fibonacci retracement theory. It may not work when it comes to cryptocurrencies. For example, if we don’t see the emergence of a swing low or a swing high – there is nothing on which to base the degree of swing. It is also up to the trader to spot these swing lows and swing highs because sometimes there can be a temptation to “see what you want to see” instead of seeing the real picture. Emotion is often the nemesis of traders!
