Complete Guide to Trading Using Fibonacci Retracement and Extension
Trading using Fibonacci has become a popular strategy in the investment world because it helps traders identify important levels for entry, stop loss, and take profit. In this article, we will discuss how to use Fibonacci retracement and extension in trading, from key points to strategies for applying them to charts.
What is Fibonacci in Trading?
Fibonacci in trading refers to a series of numbers discovered by mathematician Leonardo Fibonacci, which produces a sequence where each number is the sum of the previous two numbers (1, 1, 2, 3, 5, 8, and so on). Ratios resulting from this sequence such as 0.618, 0.382, and 1.618 occur frequently in nature and are believed to predict market movements.
In trading, Fibonacci retracements are used to identify potential support and resistance levels. In addition, Fibonacci extensions help traders determine price levels where a trend is likely to reverse or continue the previous trend.
Fibonacci Points Used in Trading
1. Commonly Used Fibonacci Retracement Levels:
- 0%: Initial level of price movement.
- 23.6%: Minor level that sometimes signals a slight correction in a strong trend.
- 38.2%: A more common level used for minor corrections.
- 50%: Although not a Fibonacci number, it is often an important level where price tends to reverse.
- 61.8%: This level is considered the “Golden Ratio” in Fibonacci and often acts as strong support or resistance.
- 78.6%: Deep correction level which is often followed by a trend reversal.
2. Frequently Used Fibonacci Extension Levels:
- 100%: Initial target for extension or continuation of the trend.
- 127.2% and 161.8%: These levels are used to estimate potential price targets as the trend continues.
Steps to Apply Fibonacci to Charts
1. Identify the Trend: Make sure you understand the current trend (bullish or bearish). Fibonacci retracement is usually applied to a recently ended trend or a correction within a trend.
2. Select Swing High and Swing Low:
- In an uptrend, select the swing low to swing high points to draw a retracement line from 0% to 100%.
- Conversely, for a downtrend, draw a line from the swing high to the swing low.
3. Drawing Fibonacci Retracement on Chart:
- On a trading platform like TradingView, select the Fibonacci retracement tool and draw a line from the swing high to the swing low or vice versa. (See Image above)
4. Using Fibonacci Levels as Support and Resistance:
- The 38.2%, 50%, and 61.8% levels are the ones most frequently retested by price. Traders typically look to enter at these levels with a stop loss below the low (for an uptrend) or above the high (for a downtrend).
- When the price approaches the Fibonacci level, pay attention to price action such as candlestick patterns or volume to determine entry opportunities.
5. Using Fibonacci Extension for Take Profit:
- After the retracement level, Fibonacci extension helps to estimate higher or lower price targets.
- Draw extensions from swing high to swing low (uptrend) or vice versa, and use the 100%, 127.2%, and 161.8% levels as take profit targets.
- Fibonacci extensions are very useful when the market is in a strong trending condition, allowing traders to capture the trend momentum well.
Advanced Techniques in Using Fibonacci
1. Combining Fibonacci with Other Indicators:
- Combine Fibonacci with other indicators such as Moving Average (MA) or Relative Strength Index (RSI) for confirmation.
- For example, if the 61.8% Fibonacci level coincides with the 200 MA on a particular time frame, then that area becomes a strong entry area.
2. Using Fibonacci Cluster:
- Fibonacci cluster is a point where several Fibonacci levels from different timeframes such as TF 15m, 45m, 1h, 4h meet at the same or adjacent price. This creates stronger support or resistance.
- This method is usually used by institutional traders who check several time frames to ensure a solid entry area.
3. Fibonacci Confluence Strategies:
- Confluence is when two or more technical tools confirm a particular Fibonacci level. For example, a support zone supported by the 61.8% Fibonacci retracement level and a bullish engulfing candlestick pattern.
- This strategy increases the accuracy of predictions and reduces the risk of false signals.
Common Mistakes in Trading Using Fibonacci
1. Over-Reliance on Fibonacci Levels: Beginner traders often rely too much on Fibonacci levels without confirming with price action or additional indicators. Remember, Fibonacci levels only provide possible turning points and do not guarantee a trend reversal.
2. Ignoring Big Trends: When drawing Fibonacci levels, many traders focus only on small time frames, even though big trends are usually stronger in influencing prices.
3. Failing to Understand Market Context: Markets can be very volatile and Fibonacci levels can be broken quickly, especially when there is major news. It is important to take fundamental news into account as a confirming factor.
Case Study: Fibonacci Application in Crypto Market
The volatile crypto market is a perfect example of how Fibonacci retracements can be used. For example, when Bitcoin is in a correction phase, traders can apply Fibonacci retracements from swing low to swing high on the daily chart to determine support levels that could allow for a reversal.
For example, in an uptrend on Bitcoin, retracements often occur at the 38.2% or 61.8% level, and then the price moves back up to the Fibonacci extension level at 127.2% or 161.8%.
Conclusion
Fibonacci is a very helpful technical analysis tool, but it needs to be used wisely and combined with other analysis tools to get optimal results. Mastering the use of Fibonacci retracements and extensions in various time frames and in combination with indicators or price action will increase accuracy and confidence in making trading decisions.
Keep practicing using a demo account to get used to it before using it in live trading. #DYOR
