Ever wondered how traders seem to predict when prices might bounce back or pause before continuing their move? One of the most important tools is the Fibonacci retracement.
It is not as tricky as it appears. Once you learn how it works, it can be one of your favorite tools to identify possible market entry and exit points. Here’s a simple guide to help you understand and use Fibonacci retracement in your trading.
What is Fibonacci Retracement?
Fibonacci retracement is a technical analysis tool that helps to determine possible support and resistance levels in the market. These are the areas where the price tends to stop, turn, or swing in the direction of a trend.
The Fibonacci retracement in your trading chart is represented by horizontal lines that are drawn at specific percentages of a price movement. The most prevalent ones are 23.6, 38.2, 50, 61.8, and 78.6 percent.
Step-by-Step: How to Use Fibonacci Retracement
Trading with Fibonacci retracement is not a difficult task; you just have to follow some simple steps.
Identify the Market Trend
The first thing that you have to do is to determine whether the market is uptrending or downtrending. Fibonacci retracements are effective in a trending market rather than one that trades sideways.
- During an uptrend, you seek to buy when the price is drawn back.
- During a downtrend, you want selling opportunities when the price increases in the short run.
Find the Swing Highs and Lows
After determining the direction of the trend, the next step is to mark the swing points on the chart.
- In the case of an uptrend, identify the last swing low (the lowest point in the movement that preceded the price beginning to increase) and swing high (the highest point of that movement).
- In case of a downward trend, reverse the process, locate the swing high and the next swing low.
The following two points are the foundation of your Fibonacci retracement.
Trace the Fibonacci Retracement Tool
The Fibonacci retracement tool is built into most trading platforms. Here’s how to use it:
- On an uptrend: Clicking at the swing low and dragging the cursor to the swing high.
- When it is in a downward trend: Click at the swing high, then move downwards to the swing low.
The Fibonacci levels will automatically be shown in your chart, typically 23.6, 38.2, 50, 61.8, and 78.6. These levels serve as possible support or resistance levels, according to the trend direction.
Notice Price Reaction at the Levels
Once the Fibonacci retracement has been plotted, take note of the price action at the retracements. In many cases, you will find the market hesitating, reversing, or creating strong candlestick patterns around these zones.
During an uptrend, when the price falls to a point such as 38.2% or 61.8% and begins to resume an upward direction, this may be a good indication to get into a buy position. During a downtrend, when the price increases to a retracement point, such as 50 percent or 61.8 percent, and starts to decrease again, it could be an excellent opportunity to sell.