Fibonacci Retracements: Understand and Apply
Here we go… absorb this like a sponge. If you are not familiar with Fibonacci retracements, this could quite honestly change the way you look at charts forever.
There are numerous tools to plot Fibonacci retracements available to traders. I’ve experimented with arcs, fans, spirals, and several others. My personal opinion is that one is all you need. I consider it a big part of my strategy when trading. This breakdown shows you the best and most accurate of all “Fib” tools.
The Mathematics and Genius
First and foremost…I greatly encourage you not to skip over the history of Fibonacci and the Golden Ratio. I think both the story and the genius behind the tool makes me that much more confident using it. Without going too deep into math and history, I feel it necessary to highlight a few points. These points will also help you understand other aspects of Fibonacci beyond retracements. Understand how the tool is effective before you use it.
The actual number sequence is naturally present within nature and first appears within our history around 450 B.C. in Indian mathematics and Sanskrit texts. It was not until 1202 A.D. that it appeared outside of India in a book called “Liber Abaci” written by the Italian mathematician Leonardo of Pisa, who was known as “Fibonacci.” An absolute genius.
The Fibonacci Sequence
The Fibonacci number sequence is 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, and so on. The sequence continues by adding the previous two numbers (1+1=2, 2+3=5) and is derived from the ratio .618 (61.8%), or the “Golden Ratio.” This ratio can be found by dividing one Fibonacci number by the next in the sequence (34/55=0.618). When squares are put together matching these measurements, a diagram is formed that creates the Fibonacci spiral, as shown below.
Spiral galaxies like the Milky Way, the distances between planets, animal reproduction rates, and genders, seashell spirals, the formation of hurricanes, growth rates of plants, quasicrystal arrangements, reflections of light beams on glass, petals on a flower, the brain, and nervous system, even the very DNA molecules that make up all living creatures are just a few examples of how the Fibonacci sequence (or Golden Ratio) is present within nature.
In 1509, Luca Pacioli wrote a book referring to the number as the “Divine Proportion,” which was illustrated by Leonardo da Vinci. Leonardo later called this sectio aurea or the “Golden Section.”
The Golden Section was used to achieve beauty and balance in many paintings and sculptures within the Renaissance period, often referred to as the greatest art period in our history. Da Vinci himself used the Golden Section to define all of his proportions in his painting of The Last Supper, which includes the table’s dimensions, the spacing between disciplines, and all proportions of the walls and backgrounds.
The Golden ratio also appears in da Vinci’s Vitruvian Man (which is well known to have perfect proportions) and the Mona Lisa. Other artists who employed the Golden Section include Raphael, Rembrandt, Seurat, Salvador Dali, and Michelangelo with his painting of the Sistene Chapel and his sculpture, the statue of David.
Other names given to the Golden Ratio throughout history include “Extreme and Mean Ratio,” “Medial Section,” “Divine Section” (Latin: sectio divina), “Golden Proportion,” “Golden Cut” and the “Golden Number.”
Fibonacci tools use this special ratio that occurs within nature to forecast support and resistance levels. It might sound crazy, but I can attest from my own experience that it works… and works well.
Alright… here we go. Applying the magic algorithm to trading stocks. By far, the most widely used Fibonacci tool is the Fibonacci Retracements. A retracement is simply a pullback or leg down. When price moves significantly, you can identify the beginning and the end of that move as the low and high, the tip of the lowest and highest candle wicks. Using the Fibonacci retracements tool, you can measure the distance of that move, and the tool will automatically place Fibonacci retracements levels on the chart. Let’s go over one. We’ll use PACB on the 15 min as our example.
To use the tool accurately, start the first point of the tool at the beginning (lowest point) of a leg up/spike/push. The final point (or click of the mouse) should be at the highest point of the move (if your charting software requires a third click, click back at the low again). The chances are that if the fibs are off, it isn’t because they are wrong; it’s likely because you didn’t measure accurately.
Same chart, but measuring the next leg up:
If finding the highs and lows is difficult for you, draw trend lines and measure those moves. You may also want to manually type in the coordinates to ensure true highs and lows.
Key Fibonacci Retracement Levels
Price action should retrace (or pull back/decline) by a ratio of the Fibonacci retracements sequence, generally a 23.6%, 38.2%, 50%, 61.8%, or 76.4% retracement. In my experience, this is true in all timeframes. Just another reason I never focus on just one. “See the product from every angle before you buy it.”
Keep in mind, in this case, you measure the move up after a top is put in. It’s a great tool at predicting a bounce. It can also be extremely useful when covering your short or entering a long trade.
You can go back over almost any chart you have recently traded and add fib lines to major moves. You will likely see what you could have done differently had you utilized this tool. Here are three different examples on one daily chart for SPY:
Fibonacci Retracements Support and Resistance
Notice on the chart below that after the top was put in on SPY, and the price fell to the .382 retracement level to first find support. Price bounces back to the .236, which has now turned into resistance. The price then bounces off this resistance and turns downward. This breaks support and continues the fall to find a base at the .50 retracement level.
Once the base formed (in this case, at the .50), the price rallied to break support.
Above, I’ve highlighted the significant drops at the support break levels. So these drops indicate heavy selling, most likely a result of longs selling, stops triggering, short entries, put options, or several other factors. Either way, it is evident that the market respects these Fibonacci retracements.
Fibonacci Retracements Entry/Exit Strategy
This is where things really get interesting. Using Fibonacci retracements effectively can signal the best entries and warn you of imminent pullbacks. Again, the following is valid for all timeframes:
Entry – These points that provide long entry opportunities (or bounces) are the .382, .5, and .618 levels. If you prefer to scale in, your first entry would potentially be the .382, with adds coming at .5 and the .618 should the price drop to that level.
If a safer trade is what you prefer, wait until the touch of the .618 and a break back above the .5 resistance for a long entry signal. Set stop just below that level.
Exit – When holding a long position, the recent low is likely behind you. With the Fibonacci retracements tool starting at that low, keep moving the ending point up as new highs come in. Remember, each fib level is a support level. If scale-out is your style, a break in the .236 would be your first sell order. The next would be the .382, followed by the .5, and a break in the .618 being your “all out.”
For a safer play, close your long position at the first sign of a pullback. If the .236 level holds, consider adding to your winner. If it breaks to the downside, close your long position.
Entry – Essentially, the signals for shorts are the opposite of longs. Following a run or move up, a break in the .236 signals a reverse in momentum, and that price may be heading down.
For the scale trade, your first entry would be a break in the .236 support to the downside, with adds coming at the .382, .5, and each break that follows. For smart trade, short at break of .236 and cover if unable to break the .382 to the downside. Set stop just above .236 level, moving down above each level that as it breaks to the downside.
Exit – Cover signals are breaks in the resistance to the upside. For the scale trade, scale-out with each break in resistance. For smart trade, cover all at first break to the upside.
So now that you understand the basics of the tool, experiment with it. You’ll be surprised at how useful it is and how quickly it will become part of your arsenal. However, if you still need a charting platform with Fibonacci retracements tools, check out TradingView for free.
Remember, the most important factor involved would be the tool’s accurate measurement. Analyze high and low candlesticks to ensure your tool is set at the very low and very high of the move to ensure accuracy with your retracement/extension lines. If you found this post helpful or learned anything you didn’t already know, share it with fellow traders.