What are Fibonacci Retracement?
Fibonacci Retracement utilises Fibonacci sequences to identify potential reversal levels. In technical analysis, a Fibonacci Retracement is created by taking the two extreme points (major peak and trough) and dividing the distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100%. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance levels. Although the 50% retracement level is not based on a Fibonacci number, it is widely viewed as an important potential reversal level, recognised in the Dow Theory.
As seen in Figure 1, the Fibonacci retracement function was applied on GBPUSD from clicking the highest point and dragging it to the most recent swing low. Fibonacci retracement levels are considered a predictive technical indicator since they attempt to identify where the price may be in the future. The theory is that after price begins in a trend direction, the price will retrace or return part way back to a previous price level before resuming in the direction of its trend.
How to use Fibonacci Retracement?
In Figure 1, we can see a major downtrend which began at Point A to Point B. The price level retraced upward to approximately 38.2% Fibonacci level before moving back down to Point C. In this case, the 38.2% level would have been an excellent place to enter a short position to capitalise on the continuation of the downtrend that started in May. Although traders were also watching the 50% and 61.8% retracement level, the market was not bullish enough to reach these points.
Some common strategies implemented by Forex traders during an uptrend include a long near the 38.2% level with a stop-loss places a little below the 50% level. As seen in Figure 3, this particular strategy would have been profitable for the trader.
Limitations
The Fibonacci retracement levels often mark reversal points. However, they are harder to trade than they look in retrospect. The levels are best used as a tool within a broader strategy such as combining other popular technical indicators including candlestick patterns, trendlines, volume, momentum oscillators, and moving averages. Combining indicators and price action patterns will equate to a more robust reversal signal.