A popular tool utilised by technical traders, Fibonacci retracement helps to determine strategic entry points, target prices or stop losses. It works on the basis that markets commonly retrace parts of a prior move before continuing in the original direction. Using ratios found in the Fibonacci sequence (most notably 23.6%, 38.2% and 61.8%) to define retracement levels, this method identifies probable reversal of trends and areas of support and resistance.
What are the important points to note when trading Fibonacci retracement levels?
1. Identify support and resistance levels
One reason that Fibonacci retracement is so widely used is that it helps traders effectively spot potential support and resistance levels. With any significant upward or downward price movement, new support and resistance levels often correspond to Fibonacci levels.
Previous support and resistance levels that line up with Fibonacci levels are closely watched by many other traders (who are also on the lookout for solid entry points) – this means that you’re likely looking at price levels with a high number of orders. Safety in numbers, they say!
2. Best to use it when the market is trending
When the market is on an uptrend, look to go long on a retracement at a Fibonacci support level. Go short on a retracement at a Fibonacci resistance level when the market is on a downtrend.
Prices are likely to find temporary support or resistance at Fibonacci retracement levels, helping you make some tidy profits when you focus on placing trades in the direction of the trend (part of a trading strategy call trend trading).
3. Combine it with other indicators and price patterns for better results
Fibonacci levels should ideally be used with other indicators and chart patterns in a more comprehensive strategy. After all, retracement levels indicate areas of potential reversal, and are not hard reversal points.
Support the use of the Fibonacci tool with other aspects of technical analysis – be it moving averages, volume, candlesticks or trendlines – to better spot or confirm a reversal.
For example, traders typically wait two to three candlestick closes above or below a retracement level to determine support or resistance before placing a trade. Remember, the stronger the confluence of the technical signals or indicators, the higher the probability of the reversal.
