Firstly, let us start with ‘Fibonacci Retracement’
What is a retracement?
Retracements are short-term price corrections during an overall upward or downward movement. These price corrections are temporary price reversals and do not indicate a change in direction of the larger trend.
Finding and trading retracements is a method of technical analysis used for short-term trades. One of the benefits of trading retracements is that they provide an opportunity to enter a trade in the direction of the main trend at a better price.
Why do retracements occur?
Technical Analysis is all about psychology and pulse of the markets. Markets and prices always move in a Zig-Zag movement. In a strong uptrend, a large number of traders enter the market and buy as they believe the market price will increase. The increased demand pushes the prices higher. As more traders notice this movement, they also start entering the market, and the increased demand further pushes the prices up. At these higher levels, traders who had entered at a lower price start to take profits, resulting in a temporary correction or retracement.
Once a retracement is seen, the trend resumes the original momentum. Most of the time we have seen that the retracement happens at one of the Fibonacci ratios of the main trend.
How to trade with the help of retracements?
Fibonacci retracement levels are often used as part of trend-trading strategies. The underlying security should be in a strong up or a down trend. Traders identify a retracement taking place within the trend – It is basically the movement of prices in the opposite direction to the main trend, and try to make low-risk entries in the direction of the initial trend using Fibonacci levels. Traders using this strategy anticipate that a price has a high probability of bouncing from the Fibonacci levels back in the direction of the initial trend.
Fibonacci levels can be useful if a trader wants to buy a particular security but has missed out on a recent uptrend. In this situation, you could wait for a pullback. By plotting Fibonacci ratios such as 61.8%, 38.2% and 23.6% on a chart, traders may identify possible retracement levels and enter potential trading positions. The same concept also holds true for a downtrend too.
How to draw a Fibonacci retracement?
In order to apply the Fibonacci retracement tool, one needs to identify the swing high and the swing low points of a trend. A swing high is identified as the highest point displayed on a given time period of a trend. It is formed when price makes a high and is followed by two consecutive lower highs. A swing low is when price makes a low and is immediately followed by two consecutive higher lows.
Using the Fibonacci retracements tool in any charting platform, the swing low and the swing high points needs to be connected. We will observe that horizontal lines are plotted as Fibonacci retracement levels. The most popular Fibonacci retracement levels are 23.6%, 38.2%, 61.8%, and 78.6% and these levels act as support or resistance depending on the type of trend.
So in an uptrend the price will retrace down to a certain percentage of the prior likewise in a downward trend the price will move opposite ie. Upward to a certain percentage of the prior swing.
Traders use these Fibonacci levels as efficient entries in the direction of the trend as many traders watch these levels and place buy, sell and stop orders on them.
How should you use Fibonacci retracement levels in an uptrend?
In an uptrend one should look to identify the area - the price finds support at important Fibonacci levels. Then we suggest one should wait for confirmation, as the price moves back into the original direction of the trend and then enter.
One important thing to note is that we must use a confluence of indicators to increase the probability of success in the trade. To support the initial analysis, should not trade solely on Fibonacci retracements, but look for other confirmatory signals too.
How should you use Fibonacci retracement levels in a downtrend?
Likewise, for a downtrend one can place the entry after the price has found resistance at one of the Fibonacci levels. Once a confirmation occurs, and when the price moves back into the original downward trend, then entry can be initiated.
How to plan your exits to the trade?
The exit strategy plays an integral part in every trade. Let us have a step by step understanding of the same.
Step 1: Deciding your stoploss.
The best place to place your stop loss is right below the Fibonacci level (in case of an uptrend) and above the Fibonacci level (in case of a downtrend) respectively.
Stop Loss level in case of an uptrend
Stop Loss in case of a downtrend
Step 2: Deciding the Target.
One can use Fibonacci extensions as reasonable profit targets.Fibonacci extensions provide good take profit levels in the direction of a trending market. Similar to the retracement levels, the common Fibonacci extension levels are 61.8%, 100%, 161.8%, 200%, and 261.8%.
The price may not always move to the desired Fibonacci extension levels, so one should not consider Fibonacci levels in insolation, but should trail the stop loss in direction of the trend so as to protect the gains.
A retracement is a short term price correction during an overall long-term up or down trend. The benefit of trading retracements is that they provide an opportunity to enter a trade in the original direction of the trend at a better price. The strategy is to buy at pull backs in an uptrend and sell rallies in a downtrend. A good way of identifying them is to use Fibonacci retracements. To set targets, one can use the Fibonacci extensions which we will learn in the next unit. As always it is recommended that one should use stop-loss that can be placed above or below the last retracements level.