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What Is Fibonacci Retracement? Definition & How To Use It


Setting the support and resistance levels is usually a problem for traders. It is especially inconvenient when trying to figure out from the beginning where to place them on the chart: one may think there are no good points to be plotted and it may be better to choose another time frame. Then the chart begins to change direction - and the support that has just been plotted becomes resistance. Immediately the question arises: "Where to build new support and how long to wait for it?"

Eventually, a breakout occurs: the trader begins to clearly see two chart peaks and two maximum declines, clearly building horizontal levels. The next revelation is understanding the principle of their operation when the price really pushes back from them and breaks up and down.

The next stage of learning strong trading lines is getting acquainted with the Fibonacci retracement. It consists of several horizontal levels which, if correctly drawn, show stages of price rise and fall in real-time mode. It means they help to determine how far the price is ready to go, up to what point it can pull back, and from what level it can continue moving in the initial direction. Thus, it is possible to learn in one fell swoop to set several levels on the chart at once, between which it will move.

The Golden Ratio In Fibonacci Numbers

Fibonacci retracement is a grid of horizontal levels drawn on a chart in one movement. The basis for the indicator was found 9 centuries ago. You must have heard about the golden ratio principle. Well, this is what is used as a mathematical formula for the indicator and allows you to use Fibonacci numbers in trading. The theory was developed by the mathematician Leonardo of Pisa. Initially, he tried to solve the problem about rabbits: "If you put one pair in a closed room, how many pairs of rabbits will be born in 12 months?"

The resulting answer turned out to be a phenomenal sequence of numbers: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987. Each next number in the chain is equal to the sum of the previous two.

Fibonacci numbers in trading have some quite curious properties, which just confirms that Leonardo has really found something legendary. So, if we divide each of the numbers by the previous one, the result will always be equal to 1.618 - the golden ratio (Phi number). For example, 610 divided by 377 would be 1.618. Test it yourself! Is it necessary to mention that everything in nature, as it turned out, is based on the golden ratio principle!

How To Read Fibonacci Retracement?

The main characteristic of Fibonacci retracement is the demonstration of the strength of directed price movement. That is, it must be a pronounced trend: sideways, flat movement is not suitable for this indicator.

Fibonacci retracement on the EUR/GBP daily chart

Fibonacci retracement on the EUR/GBP daily chart

Each of the six levels included in the standard Fibonacci retracement on your trading platform has its own features and characteristics. If constructed correctly, these lines will help you interpret the signals you receive and determine the most appropriate moment to enter the trade.

Experienced traders who have repeatedly used the sequence of Fibonacci numbers in their trading, begin to build horizontal lines by themselves, by hand, placing them "by eye". Traders argue that the market is a living structure and theoretical levels do not always reflect the whole picture and do not work out very well.

This is a controversial point: not the fact that the hand-drawn Fibonacci retracement will be more accurate than the principles of the golden ratio.

This method has its fierce opponents, who do not get any effect from trading along the Fibonacci retracement, preferring the support and resistance levels. They are not just imposed on the chart, and specifically drawn on the two upper and lower sides of the Japanese candlesticks. That is, they take into account the current picture and the balance of power.

If it seems to you that the stretched Fibonacci retracement is detached, and the real chart is located separately, and they do not correlate with each other in any way, there can be several reasons:

Try to replace the Fibonacci indicator this time with support and resistance levels or other indicators such as SMA and Stochastic.

How To Draw Fibonacci Retracement?

First of all, we need to understand the essence of this indicator. Fibonacci retracement is also called price correction levels. It means that the chart goes through them, reaches a certain level, collides with it, and pulls back a bit (either to the previous level or not reaching it). So, experienced traders do not recommend opening trades against the current trend, on a pullback, precisely because the depth of each correction is completely unpredictable and depends solely on the momentary supply and demand in the market. And getting specific trend continuation signals through a breakout of the Fibonacci retracement is a clearer reason to open a position. Let us repeat that no trading strategy guarantees a result.

And so, to begin with, you determine what the trend on the chart: sideways, upward, or downward. Only the last two options are suitable for the placement of the Fibonacci retracement.

If you are facing an uptrend, you look for the minimum point on the chart from which the price went up. If the trend is descending, you look for the maximum point from which the chart is headed downward. It is from the extreme side of the selected Japanese candle that you will pull the Fibonacci retracement.

Adding Fibonacci retracement in MetaTrader 4

Adding Fibonacci retracement in MetaTrader 4

You will find the indicator in the top menu of the toolbar: Insert - Fibonacci - Retracement. Now, hold down the left mouse button and pull out the grid to the price reversal level (the moment of correction). The 100% level will be located there. Focusing on internal Fibonacci levels, you can build a forecast of what moment the price will decide to reverse again and continue the trend. It is recommended to work with this indicator in two time frames at once: lower (M30 or H1) and higher (for example, H4).

If you are facing a downtrend, you must find the maximum price level and stretch the grid, holding down the left mouse button, until the correction of the chart. It may happen that you will immediately, with the naked eye, see a few moments when the price has already pulled back, and then regained strength and continued to follow the direction of the trend.

Then the Fibonacci retracement can be set differently: the mark of the first price pullback is 23.6%; the second - 38.2%; the third - 50%. The other levels will be set automatically. It is critical not to open a position immediately after the price has touched a level, or even more so when it starts to move away from it in the opposite direction. There is a very thin line here when the arrogance of the trader cannot resist the pressure of the market and unpredictable supply and demand.

The main helpers confirming the Fibonacci retracement signals are support and resistance levels, as well as reversal and trend continuation candlestick patterns.

You can open four chart windows of the same asset on your trading platform. The first window will be a lower time frame with the Fibonacci retracement. The second window will have a higher time frame with a grid, and the two charts below them are exactly the same, but without indicators (except for the support/resistance levels). On these, you will be able to look at the candlestick patterns with your fresh eyes: this is more comfortable because the indicators will not overlap you in the overall picture. That way you can make more informed and confident decisions about the continuation of the trend. Be sure to test such a strategic combination on a demo account.

How To Trade Fibonacci Retracement?

Experienced traders believe it's extremely presumptuous to use the Fibonacci retracement without considering the market context. This is why they look for so-called swings on the chart: combinations of three Japanese candles, in which the candles on the right and left are the highs of the chart (in the case of an up trend), or the candles on the right and left are the lows (in the case of a downtrend). This additionally indicates a reversal of the current trend.

On An Uptrend

The use of Fibonacci retracement on an uptrend assumes that you will stretch the grid from bottom to top: 0 on the bottom and 100 on the top. The price will reach the lined levels, correct down to the previous Fibonacci line, rebound from it, and continue its way further in the direction of the trend.

Until the swing reversal pattern is formed:

Such a swing will most likely occur near one of the Fibonacci levels: 50%, 61.8%, 78.6%, or 100%. It's as if the price is trying to break out of an invisible ceiling, but it fails. The next red candle may be a signal for a global reversal of the chart.

On A Downtrend

An opposite mirror situation with a downtrend. According to the recommendations, the use of Fibonacci retracement on a downtrend assumes that you will stretch the grid from top to bottom: 0 at the top, and 100 at the bottom.

You should wait for the formation of a three-candle swing pattern:

#source


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