This guide will teach you all you need to know on how to use Fibonacci Retracement in Forex along with some tips on how to use Fibonacci extensions too. There are many other guides written out there but most of them are not sufficient because in all honesty, to fully understand the art of using Fibonacci Retracements, one has to have a deep knowledge on Elliott Wave theory as they both go hand-in-hand.
In this tutorial, I will give you an in-depth guide without touching too much on the laws of Elliott Wave as that can get too confusing and we’ll leave that for another lesson. The knowledge you would get from this tutorial is priceless (or at least I hope so) and can help complement the various trading other advanced fibonacci scalping strategies we have.
To begin with, I’ll be touching on the relationship between different Fibonacci ratios and what they mean when you encounter them in your technical analysis. This sets the basic foundation to better understand how to use all Fibonacci Retracement levels.
1. What is the Fibonacci golden ratio and why is it important?
The Fibonacci golden ratio is 0.618 which is essentially 61.8%. Most Forex traders think this is the only number they should be concerned about, but in all honesty, that is further from the truth than it can ever be. There are a couple more Fibonacci ratios which are all equally important :
0.236 also known as 23.6%
0.382 also known as 38.2%
0.500 also known as 50%
0.764 also known as 76.4%
So, if there are essentially 5 levels of retracements, (23.6%, 38.2%, 50%, 61.8%, 76.4%), how exactly do we pick the level to trade off without getting stopped out multiple times? Imagine if we wanted to play a reversal at a Fibonacci level and started at 23.6% retracement, we would have gotten stopped out multiple times if it only retraced at 76.4% – see the problem there?
See the picture below for an idea of what I mean if you traded every single Fibonacci retracement level :
If you were planning to trade a reversal (in this case, buying) every blue box level (fibonacci retracement level), there is no saying whether you’ll get stopped out time after time after time. This is a problem many forex traders face, they just don’t know which level to pick and which level would give them the highest probability of profiting from a trade. In this tutorial, we’ll finally learn what are the best retracement levels to act on.
2. Breaking down the different Fibonacci retracement levels
2.1. The 23.6% , 38.2% and 61.8% Fibonacci Retracement Level
23.6% is the first retracement level you would encounter after a large move. I prefer to call this the confirmation retracement level because after a large move in one direction, price would have to break through this 23.6% retracement level to confirm that a bigger drop is about to occur.
If price breaks this retracement level, possible targets to play directly to would be 38.2 % and 61.8%.
Now, what do I mean by a large move? This is very subjective as different traders can have different ideas of what a “large” move is. If I could describe it as clearly as possible, it would be a move that is clearly “impulsive”, meaning there is little pauses or little zigzags. It’s just one powerful move. Here are a couple of examples which I can pick to give you a better understanding of it :
First Good Example :
Now, this causes a very big paradigm shift as most people are looking for play the reversals on the 38.2% or 61.8% and have never thought that they could use the 23.6% level as the confirmation level for an entry signal after an impulsive move.
2.2. The 76.4% Fibonacci Retracement Level
The 76.4% Fibonacci Retracement level is most commonly associated with the formation of a triangle pattern. That means, when you noticed that price has retraced and bounced off a 76.4% level, you should be on high alert that it is forming a triangle pattern.
This is a rule that exists in Elliott Wave theory that helps the most professional traders forecast triangle patterns way before everyone else.
Below is one examples of the triangle pattern with 76.4% fibonacci retracements. Note that it is generally difficult to trade this particular retracement level and I would personally avoid such trading opportunities that might arise from it and instead use it as good background knowledge on the possible direction of the market :
You can see that once price had made the first fibonacci retracement of 76.4%, there was the likelihood that it would do that again to form a triangle. It did that 2 more times (one in each direction) to form what looks like a really nice triangle.
How can you take advantage of this knowledge?
Well, for starters, every time price reaches the 76.4% level, you will look to play the bounce/drop (depending if it’s at the bottom or top of the triangle). This is crucial information because most people will look to play the 61.8% golden ratio and perhaps set their stop at the 76.4% level, resulting in them getting repeatedly stopped out.
However, because you know the relationship between the 76.4% fibonacci retracement level and the triangle patterns they tend to form, you are one step ahead of the market.
Also, combined with the knowledge of the impulsive moves described in point 2.1. above, you can then choose to play a total of 3 targets : 38.2%, 61.8% and 76.4% giving you more profit potential in your trades.
2.3. The 50% Fibonacci Retracement Level
The 50% Fibonacci Retracement levels actually has nothing to do with fibonacci nor Elliott Wave, although there is great use for it in deciding when really strong reversal patterns are invalidated.
An example of a strong reversal pattern and patterns which I’m very fond of myself are head and shoulder patterns, inverse head and shoulder patterns, double tops, double bottoms, triple tops and triple bottoms. If you ask me, these are the all-time most powerful reversal patterns in existence.
Below is an example of an inverse head and shoulder reversal pattern that worked out really well :
As you can see above, most conventional wisdom is that if price breaks the “neckline” which is the horizontal yellow line seen above, that would invalidate the entire inverse head and shoulder move. Most normal traders would use this conventional wisdom and get out of their position when price broke the neck line (see red box).
However, because of our superior knowledge on Fibonacci retracement levels, we know that the pattern would only be invalidated if it breaks the 50% level of the most recent “shoulder” (as seen in the red arrows). Indeed, price hardly reached that level and instead, after stopping many traders out, took off in the other direction to hit the exit potential of such a pattern.
Naturally, we would have our stop loss right below the 50% shoulder level as highlighted in yellow as that would be the level to break to signal to us that the pattern is no more valid.
3. Breaking down the Fibonacci Extension levels
3.1. The 161.8% and 261.8% Fibonacci Extension level
The 161.8% (1.618) and 261.8% (2.618) Fibonacci Extension levels are most commonly used as lottery trades where you risk a little and target a huge win. In Elliott Wave theory, this is most commonly known as the Wave 3 which is usually the longest wave.
It’s hard to tell you when a Wave 3 starts, but it usually starts after a wave 2 has been completed, which if you refer to point 2.1. above on impulsive moves, is when the impulsive move has been completed and price has retraced typically 38.2% or 61.8% – that is usually when a wave 2 ends and wave 3 begins.
The danger here, is that in Elliott Wave theory, there are just so many different ways a wave 2 can be configured (irregular patterns, zig zags, flats) so it’s very risky to play a wave 3 move – although the profit potential of getting it right is massive especially since you would have a very tight stop loss.
Here is an example of a wave 3 move to help you understand better :
As seen in the above example, we had an impulsive move (green arrows) followed by a retracement (yellow arrow). From there, there is the possibility of a wave 3 move (in all honesty, it’s really hard to forecast these moves without knowing the entire Elliott Wave structure of a market) but for those who are interested in testing out the 161.8% and 261.8% fibonacci extension levels, this is how it is done. Stop loss levels are usually placed at right below the 61.8% wave 2 resulting in a really tight stop loss and massive profit potential.
Well, in conclusion, we can see the relationship between each fibonacci retracement level. It is important that you see the art of fibonacci as a whole picture instead of just levels to play off. You might get them right once in awhile, but more often than not, you won’t unless you know the delicate nature of their relationship.
Just to drive my point home that trading using fibonacci retracements is usually easily misunderstood, you can check out the babypips guide and the dailyfx guide and see just how under prepared you would have been if you simply followed what the “social norm” is on using fibonacci retracements.
If you found this article useful, I encourage you to share it with anyone you know who trades so you help them avoid making the common mistakes people make when trading using fibonacci retracement levels.