Fibonacci retracement: what is it and how do you use it in trading?

What is Fibonacci retracement?

Fibonacci retracement denotes a type of technical analysis to identify the expected support and resistance levels of an asset.

It involves the use of several horizontal lines between a high and low point of an asset price. Fibonacci retracement levels are supposed to indicate several points where an asset's price might halt or reverse its trend. It's relatively simple to pick up how to use Fibonacci retracements, making them popular among novice traders.

How does Fibonacci retracement work?

Trading with Fibonacci retracements involves determining Fibonacci retracement levels by drawing a straight line from the lowest point on an asset's price to its highest price.

Fibonacci retracement levels are derived from the Fibonacci sequence 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233. Each new number is equal to the sum of the two preceding numbers. These ratios create the Fibonacci levels used by traders: 23.6%, 38.2%, 61.8% and 78.6%. An unofficial Fibonacci retracement level often used by traders is 50%.

Imagine that a share price rises from $20 to $25. A trader will draw a straight line between those two points before drawing four horizontal lines at the Fibonacci retracement levels. The trader will then multiply the $5 difference in the share price by 0.236. Subtracting the answer, $1.18, from the asset's $25 peak will give the 23.6% Fibonacci retracement level at $23.82.

A trader will repeat this approach for the other Fibonacci retracement levels.

How do traders use Fibonacci retracement?

Using Fibonacci retracement in day trading

Fibonacci retracement can be used as the basis for typical strategies employed by a day trader to ensure a stable trading sequence. The levels realised in Fibonacci retracement can be used by traders as markers for stop vs limit orders or to set price targets.

For example, imagine a trader is interested in Microsoft shares. Tracing a Fibonacci retracement line from a recent price movement, the trader makes an order to buy shares at a 23.6% level, anticipating that the shares could rebound at this point.

Conversely, the trader could set a stop-loss limit if the shares fall to the 61.8% level, anticipating this as a point where the stock could breach its resistance.

Combining Fibonacci retracement with a MACD indicator

Traders can use a combination of the Fibonacci retracement and a moving average convergence divergence (MACD) indicator to confirm or question their assumptions on support and resistance levels.

A MACD indicator is a trend-following momentum indicator, meaning it looks at an asset's price momentum to determine whether its trend is up or down. It uses two moving averages and a histogram.

A trader begins by using the Fibonacci retracement strategy, plotting a line between two price points and identifying the horizontal levels. They will then track the MACD indicators to confirm their perceptions based on the Fibonacci levels.

This could include identifying bullish MACD crossovers or divergences to confirm a potential support level for a stock. Conversely, the trader could confirm a potential resistance level of a stock with bearish MACD crossovers or divergences to identify a selling opportunity.

Like with day trading, traders can use this information to set price targets around bullish points, or stop-loss limits at bearish levels.

Multiple timeframe strategy

The core approach to Fibonacci retracement is a fairly rudimentary form of technical analysis that can be made more complex using different methods.

Traders often wonder what timeframe is appropriate to create a Fibonacci sequence. Day traders will typically use a short timeframe to gauge support and resistance. But another strategy is to look at a chart over the long run.

Proponents of the multiple timeframe strategy say this smooths out volatility. While short-term analysis helps with entry and exit points, the multiple timeframe approach can smooth out shocks and give a wider view of a stock's value. This makes it useful alongside fundamental analysis.

Fibonacci extensions are another way to make the sequence more complex and increase potential outcomes.

Fibonacci extensions

A Fibonacci extension adds extra price points to the typical Fibonacci retracement levels.

While Fibonacci retracements are popular for establishing the entry and exit points for a trade, extensions can be useful in establishing profit targets. Popular Fibonacci extension levels are 61.8%, 100%, 161.8%, 200% and 261.8%.

Like with retracements, extensions can be points where a price reversal may occur. They are useful in areas where other methods of identifying an asset's support or resistance are not successful.

How to trade with Fibonacci retracement

1. Learn more about Fibonacci retracement
2. Open a trading account or practise with a free demo account
3. Select your opportunity
4. Choose your position size and manage your risk
5. Place your deal and monitor your trade

Fibonacci retracement in CFD trading

You can trade options using CFDs – short for 'contract for difference'. CFDs are leveraged products. This means you don't own the underlying asset, but you're betting on its price movement. Your currency exposure and initial margin will vary according to the contract of the asset chosen.

Buying options using CFDs limit losses to the initial margin paid, and selling options can risk unlimited losses. Your wins or losses will depend on the outcome of your prediction. CFDs are popular with traders because you can offset losses on CFDs against profits for capital gains tax purposes.* Therefore, traders often use CFDs to hedge their positions.

Remember, trading with CFDs comes with added risk attached to leverage. Your position will be opened at a fraction of the value of the total position size – meaning you can gain or lose money much faster than you might expect. You'll also need to keep in mind that past performance doesn't guarantee future returns.

* Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than South Africa.

Pros and cons of using Fibonacci retracement

Pros

• Helps identify key potential levels – Fibonacci retracement is a good way to identify a stock's potential resistance and support levels. When an asset breaches these levels, it can indicate either a buy or sell point for a trader
• Easy to use – Fibonacci retracement is a relatively easy strategy for traders to pick up, given it has limited steps and a repeatable method
• Objective – Fibonacci is an objective technical indicator based on a mathematical ratio. A trader using Fibonacci levels may be able to prevent painful losses by avoiding relying on emotion or gut instinct
• Popular – Because the Fibonacci retracement is a very popular technical analysis tool, its resistance and support levels can become a self-fulfilling prophecy. For example, if enough traders set a price target at a reversal point, it could inspire the reversal to occur

Cons

• Can be inaccurate – Fibonacci retracement alone can be inaccurate in identifying the correct support or resistance levels. Accordingly, using Fibonacci retracement alone heightens risks that a trader has miscalculated the price
• Based on historical data – Like any technical analysis, Fibonacci retracement relies entirely on historical data. Historical data are not necessarily an indicator of future price performance
• Too popular – While Fibonacci's popularity can make it a self-fulfilling prophecy, it can also inhibit its effectiveness. This is because when too many traders use the tool it can lose its predictive power
• Subject to market volatility – Fibonacci retracement is unable to take into account market volatility, which tends to wipe out previous support and resistance levels. The threat of volatility accordingly makes it tough to reliably predict levels of support and resistance

Fibonacci retracement trading summed up

• Fibonacci retracement is a technical analysis tool for locating levels of support or resistance in an asset's price
• It involves a trader drawing a line between significant two points on a chart, and calculating retracement levels based on percentages. It's ideal for identifying entry and exit points
• Fibonacci can be used in day trading strategies and alongside MACD indicators. They can be extended over time and alongside wider price points
• It's relatively easy to pick up, and its popularity can make the tool a self-fulfilling prophecy
• But Fibonacci retracement can also give an inaccurate portrayal of support and resistance, and its popularity can make it less effective. Therefore, Fibonacci should be part of a wider trading strategy