As we all know, the markets first move directionally and then they retrace some of the earlier moves before resuming their original trend. If we’d know beforehand how much the market retraces before starting the next directional move we’d be millionaires pretty quickly. Unfortunately, we don’t know the future though. So what’s the next best thing? This article provides you with a tool that helps in deciding the likely retracement in the price.
This is where we get help from a 13th-century mathematician. He is known as Leonardo of Pisa or Leonardo Bonacci but most traders know him as Leonardo Fibonacci. This remarkable man from the Republic of Pisa is considered to be the most talented western mathematician of the Middle Ages.
As a young boy, Leonardo was familiarized with the Hindu Arabic numeral system and travelled the Mediterranean coast extensively. This allowed him to meet different merchants and got to know the way they used arithmetic in running their businesses. This background allowed Fibonacci to develop into a brilliant mathematician.
He is best known for what is called the Fibonacci sequence. In this sequence, each number is the sum of the previous two numbers. The sequence most first posed and solved in a document that originated in India and was related to the growth of a population of rabbits. The solution was the sequence of numbers known as the Fibonacci sequence.
The sequence is quite simple as you can see from this example (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377). Each number is just the sum of the two previous numbers. We know that generational mechanisms in nature follow this principle. For instance, the volume of a new unit in some plants is the sum of the volume of the two previous units.
Leonardo of Pisa also discovered that every number in the sequence is approximately 61.8% of the next number in the sequence. For instance, 55 / 89 results in 61.8% and so does 233 / 377. And, the same applies to 144 / 223. In fact, we could start at 21 divided by 34 and then keep on going out to infinity and we would always get a ratio of 0.618 (= 61.8%). The 61.8% retracement level is one of the most important Fibonacci retracement levels the traders use.
What about the other retracement levels? 55 / 144 gives us 38.2% and so does 21 / 55. Again 38.2 is one of the most used Fibonacci retracement levels when analysing the markets. Then there’s the 23.6% Fibonacci retracement level. This percentage value is derived by dividing a number in the sequence by another number that is two numbers later in the sequence. Take for instance 55, 89, 144, 233. If we divide 55 by 233 the result is 23.6%. 50% is not a Fibonacci ratio but it is still included in the Fibonacci retracement tool.
In this article, I will show you how these numbers can help us to identify key levels in the markets. After reading this article you will start to notice how more often than not critical price levels coincide with the Fibonacci numbers.
The correct way of using the Fibonacci retracement tool
When using the Fibonacci retracement tool we are looking to analyze how much the market has retraced from the latest peak. This is why we need to draw the lines from a prominent reactionary low to the latest reactionary high. Let’s take look at an example here.
Here I am using a prominent low as a starting point (blue arrow) and the latest high value (red arrow) to draw the Fibonacci retracement levels. This provides me with a set of horizontal lines ranging from 23.6% to 61.8%. You can see on the chart how the EURUSD currency pair retraced almost to the 50% level but then the buying started right above the level and the pair rallied higher. the price then retraced back to 38.2 Fibonacci retracement level before bouncing higher. In this example, Fibonacci retracement levels are applied on 30 minutes chart. However, due to the fractal nature of the markets the same analysis principles can be applied to various time frames.
The chart above is a EURUSD daily chart and as you can see the same analysis principles can be applied here also. I am using a prominent low and the latest high to draw the levels. This will place the 23.6% retracement level to 1.2132. When the price retraced back to the level the traders started to buy EURUSD again.
In uptrends, we look to buy at Fibonacci retracement levels and in downtrends, we look for sell opportunities as the price rallies and approaches the retracement levels. In future articles, we will look at how to combine different analysis methods with the Fibonacci retracement levels.
Traders applying Fibonacci retracement levels to intraday charts need to remember that the moves they can expect are likely to be much smaller than the moves in the daily charts. This is because the ranges in the intraday charts are smaller. In other words, the support and resistance levels are closer.
Please remember that in order to make sure you are comfortable using this technical tool or approach you have to do your own research and see if you can rely on this idea. We do not suggest you will apply any strategy without a thorough backtesting or forward testing on your part.
Hope you found this article interesting and helpful. TIOmarkets is committed to helping you to learn and develop yourself as a trader. This is why we provide you with great market analysis and other education material at TIOmarkets.com/analysis. I share from my 20+ years of experience in markets and trading and help you to become a better trader. Also, if you haven’t yet done so, open a VIP Black account with TIOmarkets. You will get a great trading environment with tight spreads and no monthly subscription or per-trade fees.
Chief Market Analyst
TIOmarkets offers exclusively consultancy-free service. The views expressed in this blog are our opinions only and made available purely for educational and marketing purposes and do NOT constitute advice or investment recommendation (and should not be considered as such) and do not in any way constitute an invitation to acquire any financial instrument or product. TIOmarkets and it’s affiliates and consultants are not liable for any damages that may be caused by individual comments or statements by TIOmarkets analysis and assumes no liability with respect to the completeness and correctness of the content presented. The investor is solely responsible for the risk of his/her investment decisions.
The analyzes and comments presented do not include any consideration of your personal investment objectives, financial circumstances or needs. The content has not been prepared in accordance with any legal requirements for financial analyzes and must, therefore, be viewed by the reader as marketing information. TIOmarkets prohibits the duplication or publication without explicit approval. FX and CFDs are leveraged products. They are not suitable for every investor, as they carry a high risk of losing your capital. Please ensure you fully understand the risks involved.
Best pair to trade today Best stocks to trade right now Best time to trade Best time to enter a trad