There are so many charting tools out there for traders to use and abuse. Many are so simple to apply to a chart, that anyone who knows how to use a computer could probably add them. But this can lead to problems. Problems in that there’s no rhyme or reason to how a drawing tool or technical indicator is used, other than that it “looks good” or “fits” a particular sequence of candlesticks. The trouble is, charts can be tricky things – they almost seem to highlight where something has worked well and mask where it hasn’t. A Fibonacci retracement is just such a tool that is so easy to apply, but so often something that traders get wrong.
I would like to show you how to effectively use Fibonacci retracements by understanding their significance and creating meaning for what they tell you. By doing so, this can help to give you something additional to lean on irrespective of how you personally trade.
But first, let’s just do a quick recap of what a Fibonacci retracement is.
Fibonacci Retracements Recap
A Fibonacci retracement is based on ratios derived from the Fibonacci sequence.
The sequence is formed by adding the prior two numbers together to form the next.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610…
As numbers go higher, the ratios of n:n-1 and n:n+1 (where n = any number in the sequence) approximate 0.618 and 1.618 respectively. This is often referred to as the Golden Ratio and it can be found, along with derivatives of it, throughout the natural world.
0.382 is 1 – 0.618 and these two numbers along with 0.5 make up what we recognize as the most common format of the Fibonacci retracement drawing tool.
Additionally, there are some derivative ratios that are frequently used. The square root of 0.618 gives us the common 0.786 value. The inverse of the square root of 0.618 gives us a common extension value of 1.272.
There are other ratios, but these are, at least in my book, the main ones.
So what on Earth does this have anything to do with how far a market pulls back or extends after a move?
It definitely feels like there’s some sort of natural order and flow to the markets and Fibonacci retracements often, if used in a discerning manner, nail turning points of a pullback.
But why Fibs in particular and not some other random ratio? Are they some kind of magical number or simply a “self-fulfilling prophesy” whereby they are used widely enough to make them work? I’ll leave that one for you to ponder.
What is certain however, is that using Fibonacci retracements in charting can be helpful to identify potential market behavior. The key factor is in that by using ratios to break up a move and applying the same ratios consistently, a trader is able to better judge how likely a market is to at least attempt a continuation move or possibly reverse.
Misinformation and Suspicion
The first problem that people face with using Fibs, as already mentioned, is where to draw them from. If you don’t have a consistent way you look to use them, you will find that there are huge number of them you can add to any chart. This usually leads to inconsistent performance of any tool or indicator.
The fact is, most Fibs are not going to be helpful to a trader. Most have very little meaning and in hindsight, it’s often not too difficult to spot one where the market has “reacted” to it. This leads on the second problem – many people use Fib levels as entry prices and do so without taking into account any price action or order flow when the market reaches them.
Misusing Fibs by treating them as entry prices in just the same way as you might misuse any other market price level, is only likely to achieve patchy trading results at best. This leads to suspicion and mistrust of the tool.
A Metaphorical Wardrobe
You can and most people do, try to apply fibs to anything and everything. This is a big part of the reason why so many people are ultimately turned off Fibonacci retracements.
But consider a scenario where you’re trying to move a wardrobe into a bedroom. It’d be sensible to measure the outer dimensions of the wardrobe, the clearance at key locations such as the bedroom door and the final spot you hope to position it in. Instead you decide to measure all of the above, but in addition to the overall bedroom dimensions, the distance you need to move the wardrobe, the wardrobe door measurements and the size its handles.
True, you have the actual measurements you need, but only amongst a swathe of superfluous information, which is only likely to confuse the situation.
If you target the key information which actually has bearing on the task at hand, you are far better equipped to judge a situation as it unfolds and take appropriate action.
A Gauge of Trading Activity
As far as trading goes, a huge piece of key information is context. Context is what the market is doing relative to what it has already done. Technical levels, Fibonacci retracements or otherwise, when used discerningly, can act as a baseline for behavior and highlight context.
There are however, contextual boulders of information and there are contextual pebbles. Even if you figure out where to draw your Fibs, there’s still plenty of scope for getting bogged down with the pebbles.
But if you figure out what’s important to you and your strategy, Fibonacci retracements can be a powerful ally in selecting high probability trading setups.
Identifying Fibonacci Retracements to Draw
For me, the key to identifying where precisely to draw a Fibonacci retracement comes down to the same thing as using any drawing tool or technical indicator – they must be used to investigate something specific about the market and not purely point A to point B.
What I mean by this is that the tool is most effective when it’s applied to a move created by something. This could for example, be a big move generated by an economic event (e.g. NFP, FOMC) or even one stemming from a change in state (e.g. a thrust as a market breaks out of balance).
Sometimes this will be the high to low of an entire move and sometimes it might start from where a move began. But what you are trying to assess is the amount of energy a move of particular significance has.
Confluence and Price Action
Fibonacci retracements do not need to be used as entry levels in order to be useful. Context alone can make them very useful. However, there are times where a specific retracement may in fact qualify as an entry zone.
It is important to remember that these levels don’t necessarily act as red light/green light levels. A market can definitely move a few ticks beyond a retracement level and it still be valid. However, there are times when if there are multiple technical factors in close proximity to a retracement price, it could in fact be a good area to look for an entry (context permitting).
For example, you might find that when you draw your Fib, the 38.2% retracement of a thrust higher, aligns with a trend line and the session open. In this case, if there’s been a rejection of lower prices, it may be an opportune area to lean on in looking for a long entry.
Two Simple Uses
There are many uses of Fibonacci retracements, but I’d like to share two with you. Please bear in mind that these are heavily dependent on your grasp of context and ability to select meaningful moves to use.
The first use is where you have a directional bias and you get a strong move in that direction. What I mean by a move is a concerted push in one direction without much if any pullback of any significance. A 20 tick move and a 10 tick pullback followed by another 20 tick move, does not count as a 30 tick move for example.
When you get a strong move in line with context and it fails to pullback through the 38.2% area, the probability of a continuation move is extremely high.
The basis of this is that you rarely see a strong move with only one attempt in that direction – there’s often a follow-through. This idea must be used in conjunction with directional context and you must have an understanding of what constitutes a large move in the product you are trading.
The second is the idea that if a move is strong, once it does extend beyond its initial extreme, the chances are high that it’ll be able to push through at least the 27.2% (1.272) extension without too much trouble.
If it doesn’t extend beyond 27.2% and then it breaks beyond the initial pullback price, the move is most likely done – at least in the short term (relative to the timeframe you’re working with).
Fib a Move, Not a Range
If you look for a big move that has some kind of significance, how the market reacts to Fibonacci retracement levels can give you a great idea of the energy the move really contains and whether a continuation is likely or not. Once you figure out what’s going on relative to a strong move, it’s not too difficult to come up with a way to make money from the subsequent action.
If you don’t have a defined way of using the Fibonacci retracement tool, you’ll be likely to start measuring ranges and by doing this, you’ll lose the ability to assess how the market is reacting to the initial attempted direction.
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