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Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors.
Before trading, please ensure that you fully understand the risks involved
Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors. Before trading, please ensure that you fully understand the risks involved

Fibonacci retracement: explained

Fibonacci retracement is a popular technical analysis tool used when trading. It is used by traders to identify future price movements when investing in their trade.

How to trade with Fibonacci

Fibonacci retracement is a popular technical analysis tool. It is used by traders and investors to identify future price movements. Fibonacci retracement levels are based on a key pattern of numbers called the Fibonacci sequence. This pattern was identified by mathematician Leonardo Fibonacci in the thirteenth century.

The Fibonacci sequence is a series of numbers starting from zero and one, where the next number is the sum of the previous two numbers. The sequence goes: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 and so on, with the sequence continuing indefinitely.

A key characteristic of this pattern is that each number is approximately 61.8% of the next number in the series. For example, 8 divided by 13 equals 0.615. In the same way, 89 divided by 144 equals 0.618. The higher the pair of numbers, the closer the ratio gets to 61.8%. This figure is known as the ‘golden ratio’.

Several other important ratios also exist within the pattern. The 38.2% ratio is found by dividing one number in the series by the number two places to the right. For example, 21 divided by 55 equals 0.382. The 23.6% ratio divides one number in the series by the number three places to the right. For example, 8 divided by 34 equals 0.235.

The golden ratio of 61.8% appears frequently in nature, biology, architecture and fine art. It is seen in flower petals, tree branches, human DNA and population growth. The golden ratio and other Fibonacci ratios are also often found in the financial markets. The ratios form the foundation of the Fibonacci retracement tool.

The idea behind the tool is that often, when a security is trending, it will pull back to a common Fibonacci ratio. When it hits that key level it will then continue its original trend. Fibonacci levels can help determine points at which a security’s price may reverse during a pullback. The ratios can be used to signal when to enter a trade.

Fibonacci retracement levels often mark retracement reversal points with surprising accuracy. The retracement levels are a powerful tool that can be applied to all timeframes, including day trading and long-term investing. Fibonacci numbers also play a crucial role in the Elliott Wave principle – a technical analysis tool used to identify market cycles. The tool can be used across many different asset classes, such as foreign exchange, shares, commodities, and indices.

It’s important to remember that Fibonacci lines are a confirmation tool. For this reason, the indicator is best used alongside other technical analysis tools such as trend lines, volume, moving average convergence divergence (MACD) and moving averages. Generally speaking, the greater the number of confirming indicators, the stronger the trade signal is likely to be.

How to use Fibonacci retracement lines

  • The first step is to identify the high and low points on a chart. For example, if a security has trended upward from 500p to 1,000p, you could use 500p as the low and 1,000p as the high.
  • Fibonacci retracement lines can be created when you divide the vertical distance between the high and low points by the key Fibonacci ratios. Horizontal lines are drawn on the chart at the 23.6%, 38.2% and 61.8% retracement levels. Some traders also like to use the 50.0% ratio. This is not really a Fibonacci ratio, but it can be useful. Often a security will retrace by around 50% before continuing its original trend.
  • Charting software has simplified the process of drawing Fibonacci lines. Many trading platforms these days enable traders to plot Fibonacci lines. In an upward trend, you can select the Fibonacci line tool, select the low price, and drag the cursor up to the high price. The indicator will mark key ratios such as 61.8%, 50.0% and 38.2% on the chart.
  • Similarly in a downward trend, you can select the Fibonacci line tool, choose the high price and drag the cursor down to the low price. The indicator will mark key ratios on the chart. To improve accuracy, traders can also use double tops or double bottoms as the high and low points.

Fibonacci retracement support and resistance

Fibonacci levels are mainly used to identify support and resistance levels. When a security is trending up or down, it usually pulls back slightly before continuing the trend. Often, it will retrace to a key Fibonacci retracement level such as 38.2% or 61.8%. These levels provide signals for traders to enter new positions in the direction of the original trend.

In an uptrend, you might go long (buy) on a retracement down to a key support level. In a downtrend, you could look to go short (sell) when a security retraces up to its key resistance level. The tool works best when a security is trending up or down.

Strategies for trading Fibonacci retracements

Fibonacci retracement lines are often used as part of trend-trading strategies. If a retracement is taking place within a trend, you could use the Fibonacci levels to place a trade in the direction of the underlying trend. The idea is that there is a higher chance a security’s price will bounce from the Fibonacci level back in the direction of the initial trend.

Fibonacci levels can be useful if a trader wants to buy a particular security but has missed out on a recent uptrend. In this situation, you could wait for a pullback. By plotting Fibonacci ratios such as 61.8%, 38.2% and 23.6% on a chart, traders may identify possible retracement levels and enter potential trading positions.

Fibonacci levels can be used across many different trading strategies. One popular strategy involves combining Fibonacci retracement lines with the MACD indicator. This strategy looks for a crossing over of the MACD indicator, when a security’s price touches an important Fibonacci level. When this happens, a position can be opened in the direction of the trend.

Another popular strategy involves combining Fibonacci levels with the stochastic indicator. This two-line indicator can help identify overbought and oversold levels. The strategy looks for key signals from the stochastic indicator when the price touches an important Fibonacci level. The two signals together indicate an opportunity to open a position.

Fibonacci retracement levels can be used across multiple timeframes but are considered to be most accurate across longer timeframes. For example, a 38% retracement on a weekly chart is a more important technical level than a 38% retracement on a five-minute chart.

As with all technical analysis tools, Fibonacci retracement levels are most effective when used within a broader strategy. Using a combination of several indicators offers a chance to more accurately identify market trends, increasing the potential for profit. As a general rule, the more confirming factors, the stronger the trade signal.

Fibonacci can be a powerful tool

Fibonacci retracement is a technical analysis tool that is widely used by traders and investors alike. The tool is used to identify trend retracement reversal levels, and is based on the Fibonacci sequence. This is a series of numbers in which each number is the sum of the previous two numbers. The pattern was identified by Leonardo Fibonacci in the thirteenth century.

A key characteristic of this pattern is that each number is approximately 61.8% of the next number in the series. This 61.8% figure is referred to as the golden ratio. The golden ratio appears frequently in nature, biology, architecture and fine art. However, the golden ratio and the other Fibonacci ratios are also found frequently in the financial markets.

Often, when a security pulls back from its underlying trend, it will find support or resistance at a Fibonacci level. As a result, traders use Fibonacci retracement levels to identify support and resistance levels. These levels can be used to identify potential trade entry and exit points.

Fibonacci retracement levels can mark retracement reversal points with surprising accuracy. They can be used across multiple asset classes and timeframes. As a result, the levels are used in many different trading strategies. Fibonacci retracement levels are often combined with other popular technical indicators as part of a broader trading strategy. When combined with other indicators, it can help traders identify and profit from trend reversals.

Source: CMC Markets UK

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