How to Use Fibonacci Retracement
There’s a lot of online crap on Fibonacci retracement that hope to improve one’s trading. Most of those articles are only half-baked and will cause more harm than good.
Some of them are good, some are bad, and some of them are plain ugly. None of which are complete — including the Investopedia one.
I will show you how to use the levels based on volume, moving averages and supply and demand trend lines. This will introduce a new dynamic and accuracy to your trading. You will learn how to use the sequence to enter and exit trades in the most profitable way.
I have been using this strategy myself to much success, yielding a green PNL since 2008. I am sharing this with you today, so buckle up and let’s go!
This Fibonacci guide
You will discover how to draw the sequence properly. A lot of people get it wrong and their analysis is skewed from the start.
Then, you’re going to learn how to confirm price movements when it breaks through a Fibonacci level. You know, to see whether to enter a trade or wait out.
Next, you will find out how to set stop loss orders and targets. Not too narrow and not too wide — just right. Also through a filter of preserving as much of the capital as possible.
And finally, I will round off the guide with some meaningful examples.
You might wonder why you need to take these extra precautions.. I’ll tell you why.
Fib levels look good on historic charts when the price had already marked its trail. At that point, everyone is an expert and a know-all. It seems so simple and obvious, and yet, most people lose money in the market. Why? Because the Fibonacci retracement on its own, just plain and simple, doesn’t work.
Fibonacci retracement doesn’t work
Strangely enough, the historic price data always corresponds with the Fibs, right? But then, it doesn’t — that is, if you look to the right side of an empty chart.
It’s a different story when you’re in the live trade with an open position. You’re wondering where the price goes this time. Things aren’t clear anymore. You have these pretty Fibonacci colours overlaid on the chart and nothing. You still happen to hit that SL more often than you’d like. Or bust your trading balance altogether if you don’t have one.
There’s a solution. And this guide provides that.
You need volume to verify the future price action as well as its momentum and direction.
You must use EMAs (exponential moving averages) to spot a build-up of support and resistance areas.
You have to validate all the above with the supply and demand lines. Just to see where the market is headed and make a decision whether to go along with it or not.
That’s when Fibonacci retracement makes sense and generate money in the long haul. That’s when it becomes complete. Never on its own. Otherwise, it’s a recipe for disaster and you’re the only one to take it on the chin.
Things things first though. Let’s start with the boring basics and keep it simple.
What is Fibonacci retracement
The Fibs tell you where the hidden support (S) and resistance (R) areas occur.
You create the Fibonacci retracement levels by taking an extreme low and connecting it with an extreme high — in a bull market. By contrast, in a falling market, you link a significant high with a significant low to the right.
The distance between these two points is then divided by the Fibonacci ratios of 23.6%, 38.2% and 61.8%.
50% is the middle point and plays a less significant role in our strategy, although, it cannot be ignored.
Note that every support acts as resistance. And every resistance acts as support. It depends on what side of the S/R line the price is. The same principle applies to Fibonacci.
The ratio breakdown
Each level is unique. The higher or lower you go in the sequence, it requires more effort for the market to break through it.
The 50% level is weak and applies a modest support/resistance pressure . You are likely to see the price bounce between the 38.2% and 61.8% without much consideration of the middle point.
The 38.2% & 61.8% levels are usually tougher for the price to pierce through. You should expect a decent number of pullbacks and corrections from these. If they break on high and/or expanding volume, the price is likely to travel to the next. But not always — it will take volume to determine this.
The 23.6% & 78.6% are strong S/R areas. The price will test and rebound from these levels more often than break them. That’s where you want to focus your efforts on placing trades. It will offer you a high R/R ratio and a peace of mind as they’re rarely broken. If smashed, and more so, on high or expanding volume, a trend reversal is in the offing.
The 0% and 100% are your swing high and swing low. They’re the strongest S/R levels and rarely tested by the price. You should place long trades around the 100% line or go short near the 0%. The price is unlikely to break through either of them. If it happens, though, they act opposite to what they were before. Support becomes resistance (and vice versa), and trend reversal could be the case.
Let’s see how to draw the retracement.
How to draw it (properly)
In an uptrend, you want to draw the lines from swing low to swing high.
In a downtrend, you go from swing high to swing low.
Here’s the most important bit:
The retracement should start not always at the highest or lowest point, but at the start of a substantial rally or at the end of a decline. It means that you shouldn’t always draw it from — to the lowest or highest candle wick. This method is one of the most effective ways to draw it properly. Take a look at the example below.
Do not attempt to draw the lines off of the wicks every time, otherwise you will end up with imaginary levels. This is crucial to understand — it drastically impacts the precision of the entry, exit, SL and TP points.
It also hampers the risk to reward ratio since your stop loss is either too wide or narrow. The longer the wicks and the farther they are from the start of a rally or the end of a decline, the more out of sync the retracement is.
The most important indicator employed in conjunction with the sequence is volume. It should go hand in hand with any other technical analysis strategy also. Without it, you’re playing hide and seek in the dark.
If you don’t know what volume is, here’s a brief Investopedia definition for it:
“Volume is the number of shares or contracts traded in a security or an entire market during a given period of time. For every buyer, there is a seller, and each transaction contributes to the count of total volume. That is, when buyers and sellers agree to make a transaction at a certain price, it is considered one transaction. If only five transactions occur in a day, the volume for the day is five.”
Volume is usually represented in vertical bars. Each bar corresponds to the number of transactions per cycle. If you’re analysing an asset on a 3-hour time frame chart, each cycle equals to a 3 hour candle and so on.
You don’t need to know how many transactions each bar contains. Pay attention to the average line that goes across the bars instead. If the bars shoot above it, you take special interest in it. And contrary to this, if they are non-existent or small, you want to be aware of it, too.
The volume indicator comes with a moving average. The average input you will be using in conjunction with the Fibonacci sequence is set to 50. Being set to this number, it offers the most accurate.
Fibonacci + volume
What you are looking for is the moment the price breaks through a Fib level and closes within a new one.
If it does so on high or expanding volume, it’s a signal the movement is likely to continue, and even test the next level.
High volume is anything above the 50 MA on the volume indicator. The higher the volume on a level break, the stronger the signal. Especially if the volume is growing in the following cycles.
To determine an expanding volume pattern, you need a sequence of at least 3 volume bars. Each bar must be higher than the earlier one for the same colour. Opposite to rising volume, you seek the contracting one (stopping volume).
As it always is with analysing the price on a chart, this is not always the case. There will be exceptions to this and you can’t help it. Although, this will work most of the time. How far the price goes also depends on any possible roadblocks along the way, ie. horizontal S/R, local top/bottom or all-time high/bottom.
It’s important to get the right balance when using volume as confirmation. The higher the time frame, the more accurate this type of analysis gets. Intraday traders that use smaller time frames will experience less accuracy.
As a side note, it doesn’t apply to the Fibonacci retracement being run through the volume indicator only, but to any other strategy, too.
Examples of Fibonacci + volume
Another thing we need is two sets of exponential moving averages (EMA). To understand what an exponential moving average is, you need to revert back to a definition of the simple moving average (SMA):
SMA is a line drawn on a chart that represents an average of all closing prices within a given cycle. The average is a true average of all the cycles.
EMA employs the same plotting principles as an SMA, but puts more weight on the most recent price action. To put it in other words, it’s more accurate and less rigid.
Fibonacci + EMAs
Add EMA-50 and EMA-200 to your chart. These will show you significant support and resistance areas on every time frame. The price usually considers their existence and behaves in a somewhat predicted manner.
What you want to look out for is a build-up of S/R areas. A Fib level itself is one of them. And so is an EMA. It will happen that both of them line up together to create a support or resistance cluster. It will take an immense effort for the price to break through a build-up like that. Use these to enter trades or exit at a profit. They will also serve you well as a stop loss mark during a live position.
Now, imagine a Fibonacci level lined up with 2 moving averages at the same time. It would be even harder to for the price to penetrate to a cluster like that.
Generally speaking, the more S/R build-ups you find, the higher the probability of a reversal. If the price does penetrate through it on high volume, such clusters will act opposite to what they used to be. As you’ve found out earlier — resistance becomes support and vice versa.
Supply & oversold lines
The supply line indicates where the current supply exists within a downtrend. It’s a line that’s drawn by connecting two descending highs.
To complete the picture, you must draw the oversold line, too. That’s a line that’s drawn parallel to the supply between the two descending highs.
Take a look at the example:
Use these to enhance your support and resistance clusters.
Demand & overbought lines
Opposite of the above.
The demand line shows where the actual demand kicks in within an uptrend. Contrary to the supply line, you draw it by connecting two ascending lows.
The overbought line goes parallel to the demand at the highest point between the two lows.
The practical use of the supply and demand lines is a complete strategy itself. It requires a separate article to explain and is outside of the limited scope of this guide. Although, for now, all you need to know is this:
You are looking to enter the market near the danger points. A danger point exists near either side of these lines. For example, in a bull market, you want to enter a trade when the price is approaching the supply line. Your target is the opposite end of the channel.
At first glance, it looks like an unreasonable strategy. But the price is likely to trend within the channel and pull away from it. If it was to break the demand line, it’s a clear signal that the trend had reversed.
Place stop loss orders outside the demand line to prevent losing capital. SL must correspond with other plausible S/R areas, or even better — clusters.
Test it out for yourself and notice that the price will more often pull back from the line than break through it.
When the price travels to the overbought line and volume is light, you seek to enter short trades. Place SL orders outside the overbought line and set your target at the opposite end near the demand line.
Contrary to the above, you do the exact opposite in a downtrend.
There will be times where you can’t draw any oversold or overbought lines because they wouldn’t make much sense. It happens when the price casts too large spreads. Or too narrow, making the channel too small for the price to breath within. Or right after a buying or selling climaxes. They will still be useful to determine S/R clusters.
If that’s the case, go with the supply or demand lines instead. This is an example:
How to set stop loss orders effectively
If you think of it, an entry, exit, SL and TP points are the same thing. The price doesn’t distinguish those. For the price, it’s the same dynamic, but different outcome to you. The only variable that dictates your outcome is time. It’s the time that relates to the stage of your trading position.
Whilst you’re within a live trade, you’re looking to accomplish two things. You want to exit at a profit and limit your losses. When you want to enter the market, you want to ensure you do so at the right moment, too.
How do you do that? You look for the support and resistance markers. These are Fibonacci lines, EMAs and demand/supply lines. All accounted for at the same time, and each verified by volume.
You can take advantage of every S/R build-up area to single out either of the above. That is — the entry point, stop loss order and take profit price.
You see where I’m going with this? It couldn’t be simpler. That’s why Fibonacci retracement doesn’t work on its own. But now, since you’re equipped with stuff that will boost your earnings, you’re going to enjoy it again.
Putting it all together
By now, you should know what the Fibonnaci sequence is and how to draw it. You also know how to plot S/R clusters to gain accuracy. It’s time to digest some charts and put the theory to a test.
Ready? Let’s go!
This is a complete strategy that works. Most of the time. That’s because nothing works 10 out of 10 times in trading. But it will definitely shift the odds in your favour over the long-term.
Test it for yourself and let me know your thoughts. Good luck!
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