Technical Analysis Part 5: What Is Fibonacci Retracement?

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what is fibonacci retracement

Welcome back to part 5 of our series on Technical Analysis. Today, we are going to learn about the Fibonacci Retracement levels. If you are new, then here are the first four parts:

Today, we will be looking into Fibonacci Retracement.

Who was Fibonacci?

Leonardo Pisa or Leonardo Bonacci was born at the beginning of the 12th century in Italy and was a significant mathematician who changed our lives as we know it. As he studied and became more knowledgeable, he introduced the Hindu-Arabic numeral system and the Fibonacci sequence to the western society. Thanks to Leonard, also known as Fibonacci, we don’t read in Roman Numerals today.

Fibonacci spread the new numeral system after releasing a calculation book, “Liber Abaci,” adapted from an older Indian Method. Leonardo used the theory to solve problems related to the growth of the rabbit’s population, and the solution was a sequence of numbers that eventually became known as the Fibonacci Sequence. 

What is the Fibonacci Sequence?

The Fibonacci sequence is an endless numeral pattern, which involves adding the previous two numbers starting from 0 and 1 to continue the pattern. For example, the following is the Fibonacci pattern:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377…

what is fibonacci retracement

What Is The Golden Ratio?

After more studies and an in-depth look into the sequence, we can find a ratio that consistently appears and continues the progression starting from 3. This ratio is called the Golden Ratio (phi = φ) and is often referenced as “The Most Beautiful Number In The Universe.” 

The reason φ is so extraordinary is that it can be visualized almost everywhere, as explained by Leonardo. The number 1.618 would be the ratio of the next number, and 0.618 would be the ratio for previous numbers. The ratio may have a slight deviation in the sequence, but it should always be close to the 1.618:

what is fibonacci retracement

How can Fibonacci help us trade?

Before we jump into the graphs, let’s look into the other Fibonacci levels. The tool to trade connects any two points that the trader views as relevant, typically a high point (top) and a low point (bottom) of a clear market swing. The levels are 23.6%, 38.2%, and 61.8%. In addition to that, we have 78.6 % and 50% levels that are not officially a Fibonacci ratio. However, it became common among Fibonacci believers to also indicate support and resistance levels. The support and resistance are key levels to watch how the market approaches and behaves there. 

The 38.2% ratio comes from dividing a number from the sequence by the number located in two spots to the right. For example, 5 divided by 13 equals approximately 0.381. The 23.6% ratio comes from dividing a number from the sequence by the number that is three places to the right. For example, 8 divided by 34 equals about 0. 24. The golden ratio (phi) tends to be the point where the market turns around forming a bottom or a top.

Those levels are critical as there is more pressure between the buyers and sellers. Traders often use it to place their stop-loss orders accordingly. The price should break through each resistance during a bull run or upward trend and create a new support level instead. It is common to see the price retest the new support after the breakout to ensure the market is ready to continue the movement. Users can apply the opposite idea during a bear trend.

As a resource in candlestick trending, we can apply the Fibonacci extension for upward price projection or Fibonacci retracement for downward projection. Each support may provide strong resilience and, therefore a potential trend reversal.

How to use the Fibonacci levels

A trader can take advantage of using Fibonacci retracement and extension analysis to trace a robust trading plan. Applying the tool will allow them to “time” the cycles by identifying levels where the market is more likely to reverse and, therefore, enter or exit the market. In addition, the support and resistance will help “time” the market based on price oscillations when hitting each Fibonacci level. Let’s take a closer look:

Fibonacci price extensions will provide projections based on an initial upward movement. The trader would need to identify the three main points to apply the tool and identify the supports, resistances, and higher target levels that the price may reach in the future. The three points are:

  • The lower point from a potential bottom.
  • The peak on the significant upward movement.
  • The point the market reverts to continue with the trend.

Fibonacci price retracement is price movement from a prior low to high swing to identify possible support levels where the market recovers before continuing with the downtrend. The retracement would be between the initial high or peak and the low or bottom points selected. In this case, we would need to identify the downtrend and the significant swing and apply the Fibonacci retracement.

The steps for both cases would be similar and are presented below:

  1. Identify significant peaks and bottoms (highs and lows) to locate the outstanding price swings.
  2. Run all possible Fibonacci price relationships on the clear trend.
  3. Look to spot trade setup based on candlestick patterns and previous levels by zooming out and looking to the left to compare previous price actions (if any). 
  4. If a setup is identified, look for an entry or exit opportunity by placing limit orders close to Fibonacci levels.
  5. Once the order is triggered, address and manage positions by adjusting stop-loss between levels.

Seeing The Fibonacci Retracement Levels At Work

Chart 1

what is fibonacci retracement

In the example above, we can see the asset price peaking very close to the 3.618 extension target, entering the purple extension level at the upper right and initiating a trend reversal. As the market breaks through the resistances, the stop-loss orders should move below the new support accordingly to maximize profits. This strategy would have worked well from almost every resistance and support starting from the 0.382 in yellow level until the peak.

Chart 2

what is fibonacci retracement

We set the support and resistance levels using the top and bottom wicks of the candlesticks selected. Those levels were selected as the price strongly breaks the bearish trend line, indicating a temporary bottom and an opportunity for a potential pullback before a trend reversal again. Depending on the timeframe, you may see the candles with larger bodies and smaller wicks, this may help determine which point would be more relevant on the swing in price. The 0.618-level was the main resistance where the price failed to continue the trend and initiated a trend reversal. 

This scenario presented an opportunity to either buy after the downtrend line was broken and manage stop losses to exit the market on green and new peaks at all-time highs. Or a chance to exit the market if the trader was holding the asset. The opportunity to sell would have been after the third attempt of passing the 0.618 level and seeing a bearish rejection to proceed with newer highs. Instead, the price entered the light blue level and didn’t manage to hold above.

We understand it is easier said than done. However, measuring risk and placing stop-loss may vary depending on each trader. Some traders may not accept losing more than 1 or 2% of the trade. Others may prefer to give more room in case of support retest, long wicks, and measuring the risk to the reward as cryptocurrencies may have strong upward movements each portfolio is different.  

Fibonacci Retracement: Conclusion

Fibonacci introduced an amazing theory that impacts everyone indirectly or directly. The theory became relevant for traders and many other aspects of our lives. The price of all assets in the world will present a funny behavior when approaching those levels and if using the correct strategy, it can be very profitable. Fibonacci levels and candlestick combinations allow traders to set their orders and maximize their odds of a successful trade.

Some assets are more volatile than others and it may impact projections on the retracements and extension levels. Therefore, there is no guaranteed or fixed price behavior that an asset should follow. However, the Fibonacci retracement and extension help us determine support and resistance levels with accuracy. From there, set a trading strategy using limit orders to enter or exit the market and protect the capital by setting sell-limit orders. The more familiar traders are with the graphs, the better they will plot the opportunities and use the levels for a better trade.

A combination of factors like trend lines, candlestick patterns, and indicators will help determine the overall price direction. The most significant levels where the market may continue the trend, accumulate or revert. 

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