What is Fibonacci Sequence in Trading and how is it used?
The Fibonacci sequence is a series of numbers in which each number is the sum of the two preceding ones, usually starting with 0 and 1. The sequence looks like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, etc.
What brings Fibonacci into the spotlight for traders is that some ratios derived from the sequence—known as Fibonacci ratios—are frequently observed in nature, architecture, and even the financial markets. These ratios are:
- 61.8% (the Golden Ratio)
- 50% (not a Fibonacci number but very common in trading)
- 38.2% and 23.6%
Fibonacci retracement levels are popular indicators in financial markets as they can help traders determine potential support and resistance levels based on previous price movements. Retracement levels are used by traders to predict at what price the price will reverse or stall, providing vital entry and exit points.
Trading In and Out at Core Fibonacci Ratios
- 23.6%: A shallow retracement level. More typically after price has made a strong movement, and is used to identify minor pull-backs.
- 38.2%: This is the second most popular Fibonacci retracement level and is often viewed as a healthy pullback. Traders use it to determine if the price is likely to continue in the direction or reverse.
- 50%: Not ‘technically’ out of the Fibonacci sequence, this is a level widely used by traders, as this one tends to be an important psychological level in the market.
- 61.8%: The most important Fibonacci Ratio. Price action at this level is seen as a significant potential reversal zone by traders. It is most commonly known as the "Golden Ratio" and is the most critical Fibonacci retracement level.
- 100%: Completes the full extension of a prior price move.
These ratios can be used to plot Fibonacci retracement levels on a chart; price levels at which an asset may find support or resistance.
How to Use Fibonacci Retracement in Trading
This essentially indicate areas of potential reversal of the market after a big move (up or down). Fibonacci retracement levels indicate where the market is likely to retrace before continuing to do so in the original direction and is determined by measuring the distance between a recent high and low.
How to Use Fibonacci Retracement: 5 Steps
- Find Trend: Step one is to determine the trend (uptrend or downtrend). The Fibonacci retracement tool works best when used in a trend because it allows you to find possible levels of support or resistance for retracement.
- Choose a Fibonacci Tool: Most charting software has access to these tools, and popular platforms, such as MetaTrader and TradingView, have them built-in. To use the tool:
- Then to move up, click at the bottom of the move (low) and drag to the top (high).
- For a downtrend, click at the top (high) and pull down to the bottom (low).
- Set your turn point: After applying the Fibonacci tool the retracement levels will be displayed on the graph. These are considered potential support (in a bull market) or resistance (in a bear market) levels.
- Wait for Confirmation: After the price has reached one of these levels, identify additional confirmation signals — such as candlestick patterns (e.g., engulfing or hammer), or other technical indicators (e.g., RSI, MACD) — that support a reversal.
Use of Fibonacci Retracement in Practice
When a price rises in an uptrend and begins to retrace, traders will mark the price using the Fibonacci retracement tool from the previous swing low to the swing high. The Key 38.2%, 50%, and 61.8% Levels: Components Traders Identify for Potential Price Support and Reversal If the price moves back to the 61.8% and then forms some bullish candle patterns, they may enter long positions expecting the trend to continue.
Fibonacci Extensions: Extending the Strategy
While Fibonacci retracements ensure that traders recognize potential reversal areas in an active tendency, Fibonacci extensions, however, and are used to predict future price levels when the uptrend continues.
Fibonacci extensions are used to identify price targets after a breakout above or below a previous swing high or swing low. Common levels of extension are 161.8%, 261.8%, and 423.6%
How to Use Fibonacci Extensions: A Step-by-Step Guide
- ASCERTAIN THE TREND: Like retracements, you want to ascertain the overall trend.
- Using the Fibonacci Extension Tool: In your charting software, select the Fibonacci extension tool. Click at the swing low (the start of the uptrend), then at the swing high (the end of the uptrend), and then at the swing low again (for the retracement).
- Find the Target Levels: Fibs extension tool shows these levels above 100%, such as 161.8%, 261.8%, and 423.6% where price may land if price continues the trend.
Fibonacci Extension: Example in Action
Assuming that the price is in uptrend and it releases a pullback to the 50% Fibonacci level. Should the price breakout the prior high, the Fibonacci extension tool allows traders to project possible price targets at 161.8% or 261.8% extension levels. Traders like to use these levels to establish profit-taking targets for their trades.
Fibonacci in Conjunction with Other Technical Indicators
By themselves, Fibonacci retracement and extension levels can be powerful, but can become even more useful when combined with other technical analysis tools. Here are a few common approaches:
Using Candlestick Patterns
- Keep an eye out for Pin bars and Engulfing candles: These patterns can give further confirmation at key fib levels. A bullish engulfing candle at the 61.8% retracement could indicate a strong buy signal, for example.
- Doji Candles: indicate indecision and generally appear at or near important Fibonacci levels indicating a potential reversal.
Using Oscillators (RSI, Stochastic)
Fibonacci levels are common retracement levels that traders use to identify potential price level overbought/oversold zones. RSI (Relative Strength Index, RSI is frequently used with Fibonacci levels to verify overbought or oversold situations. This can become a sign of a reversal if the price crosses a 61.8% Fibonacci retracement level and RSI goes into an overbought state (higher than 70).
The stochastic oscillator is another overbought or oversold indicator which provides confirmation on entry points when the price reaches Fibonacci retracement or extension levels.
Fibonacci Trading and Risk Management with Position Sizing
Successful Fibonacci trading hinges on risk management. If you have a good strategy which works on losing trades too, it can help you secure your capital and ensure long term profitability with proper position sizing and stop-loss placement.
Stop-Loss Placement:
- For Retracements: Set stop-loss orders slightly under (for long), or slightly over (for short) the Fibonacci level.
- For Extensions: Position Stops under the Last Swing Low (Below in a Bullish Trend) or above the swing high (in a bearish trend)
Position Sizing:
As a general guideline, only risk 1-2% of your trading capital per trade. Use the distance from your entry to your stop-loss to affect the size of your position.
How to take over Fibonacci trading — Expert Insights
Fibonacci Basics First: Spend time with the core principles of retracements and extensions first, before delving into advanced strategies. The Fibonacci retraction levels are some of the oldest technical tools, so it is imperative that traders understand the basic Fibonacci levels and how they can apply to price action.
It marks the period when many of these assets started to move. It will build your confidence to use them in live trading.
Key Takeaway:
Fibonacci trading takes time. Patience is the game, wait until the market comes into serious Fibonacci levels before deciding to pull the trigger. Entering too soon can cause false signals.
Use in Conjunction with Other Resources:
Avoid placing use of Fibonacci tools in a vacuum. Combine them with other technical indicators; like moving averages, volume analysis, and candlestick patterns for stronger signals.
To Conclude — The Fibonacci Trading Strategy: Is It For You?
Fibonacci trading is a powerful method used to identify potential price reversal areas and predict future price movement. Therefore, if a trader knows the core Fibonacci retracement and extension levels, uses a strategy alongside other technical tools, and practices solid risk management — Fibonacci tools can be an essential component to your forex and crypto market success.
FAQs (Frequently Asked Questions)
- What Fibonacci level is best for trading?
- The 61.8% retracement level is the most commonly regarded as critical because it represents the “Golden Ratio.” However, the 38.2% and 50% levels are also quite important.
- Do Fibonacci level work on any market?
- Yes, Fibonacci levels can be used across markets, including forex, stocks, commodities, and cryptocurrencies. They’re particularly useful in trending markets.