Fibonacci retracements work really well, but only if they are drawn properly. There are many ways to draw them and I can confidently tell you that the majority of what you find online is wrong, sadly. Today, however, I hope to teach you the correct way to draw Fibonacci retracements to find key levels to buy and sell from. This is the first step to really unlocking the key to profitable trading in forex – trust me.
What makes me qualified to teach this tough subject?
- Former technical analysis advisor to the largest banks and hedge funds including Goldman Sachs, Brevan Howard, Citibank and Nomura.
- Currently runs the technical analysis division of the largest brokers including IC Markets, Tickmill, FXCM, Pepperstone and 10+ more.
- Learnt my craft in the largest forex research house.
- Backed by a team of CMT, CFTe and CFA accredited analysts.
- Master in Elliott Wave and Harmonics (which is where a lot of the Fibonacci tricks come from).
Now, the trick to knowing how to draw Fibonacci retracements correctly comes from knowing that inherently, they come from chaos theory and have close links to Elliott Wave and Harmonics. We will leave that can of worms unopened first as I drill down into the correct ways to look at the swing high and swing low points of the chart where you will be drawing your Fibonacci retracements from.
Can Fibonacci Retracement work in choppy markets or trending markets?
Yes, Fibonacci retracements are meant to work in both choppy (range bound) markets and trending markets. The key is in identifying the correct time frame to analyze it on (eg. H1 chart, H4 charts, M15 charts). What I mean by this is sometimes the H4 timeframe charts look choppy, but when you zoom into the H1 charts, it looks much clearer with more defined trends.
At the very basics, the clearer the swing low, the clearer the swing high and the clearer the “trend” between these 2 points, the more accurate a Fibonacci Retracement will be. Now, when I say trending market, this doesn’t mean those super long trends that last for months and years. It all depends on the chart time frame you look at. You can be looking at a M15 chart and say “wow this has to be a mega trend!” but when you take a step back and look at it, it is only a chart showing a few days. Any time frame can have a trend, albeit it can be either a short term one or a long term one.
At the very basic level, fibonacci retracements mean to simply take the vertical distance traveled by a move (eg. 100 pips) and divide it by a few fancy numbers.
The Fibonacci Retracement Levels That Work (Tried and tested over years)
- 76.4% or 78.6%
- 127% (this means that the fibonacci retracement goes beyond the 100% level)
- 161.8% (same for this)
You can easily divide these numbers by drawing a simple line from the start to the end of the move. To do that, we have to :
- Identify the recent trend – prices going down or up?
- Identify recent swing lows and recent swing highs
- Connect the 2 extreme points – highest to lowest (downtrend), lowest to highest (uptrend)
Now you have Fibonacci retracement lines showing you when you can expect a bounce or a reaction (drop).
To find key resistance levels: Our first dot would be the highest point and our second point will be the lowest. (Up, down)
To find key support levels: Our first dot would be the lowest and second being the highest (Down, up).
IMPORTANT : Your starting and ending points should never have any bars to the right that ‘breaks’ it. So for downtrends with an ending point that is the lowest point of the trend, there should not be any bars that are lower than it. You can better understand it through this illustration :
This is a correct example of taking the highest starting point to the lowest.
When does your Fibonacci Retracement become invalid?
Yes, there are times when your Fibonacci Retracement becomes invalid. One of the most common scenarios of this is when price makes a lower-low (assuming you are drawing a Fibonacci retracement from the top to the bottom like in the picture below.
If there are bars on the right that ‘break’ your ending point, it becomes invalid. Here’s an example :
You can see that you should essentially be taking what I call the ATL (All Time Low) as your ending point if you are drawing a Fibonacci retracement from the top to the bottom (hence finding resistance levels).
Is a Fibonacci Retracement enough to trade profitably?
Short answer: No
The simple fact is : YOU WILL ALWAYS FIND FIBONACCI RETRACEMENT LEVELS.
Imagine using the example above, I told you to sell when price reaches the 23%, then the 38%, then the 50%, followed by the 61.8%, then the 78.6% and on and on and on. What’s going to happen at the end of that? Well, you would have lot a lot of money and probably be spending a bit more money to buy that next plane ticket to find me and kick my teeth in (which I really do not wish to happen).
The trick to trading Fiboancci retracements profitably, is in using them in conjunction with other Fibonacci levels. This includes other Fibonacci retracements from a bigger/shorter trend, using Fibonacci extensions (we will cover this), using support and resistance (correctly) and also price action. What this results in is you increasing your odds tremendously on getting into profitable trade setups. Essentially, you are trading something called Fibonacci Confluence which is where the beauty of chaos theory comes in.
How to combine Multiple Fibonacci Retracements to create Fibonacci Confluence?
Fibonacci Confluence is essentially combining multiple fibonacci levels (can be retracements or extensions) to find clusters where these Fibonacci levels congregate. The area where they congregate would pose as a strong level to play a trade from.
Now, when you try to do Fibonacci Confluence, you’ll need to ensure you really know how to draw Fibonacci properly because you are multiplying the chances of you drawing it wrongly (and hence trading wrongly and losing money) as you draw more and more Fibonacci retracements to get that confluence.
You have to be very picky of the ones you pick. I always have a simple rule of 3 I go by. So for a Fibonacci retracement level to be valid, it needs to have :
- 1 x Fibonacci retracement from a short term trend
- 1 x Fibonacci retracement from a long term trend
- 1 x horizontal support or resistance level
Once I can see at least these 3 criteria in a setup, then I will accept the fibonacci level.
To better illustrate this, let’s use the 4 hour AUDUSD chart as an example.
Fibonacci retracement in a downtrend
First, prices are going down, which makes it a downtrend. Next we identify the swing highs and swing lows. Since it is a downtrend, we start from the swing high and join it to the swing low. We can draw the fibonacci retracement from our long term trend (red) and our short term trend (gold). Do we meet these 3 criteria I set up above? Let’s take a look.
- We found a 23.6% Fibonacci retracement from our long term trend (red).
- We found a 38.2% Fibonacci retracement from our short term trend (gold).
- We found a horizontal overlap resistance right at the same level as our Fibonacci retracement.
Since all 3 conditions are met, I would determine this level as a strong resistance level for me to either set a stop loss at or sell entry at.
Fibonacci retracement in an uptrend
First prices are going up which makes it an uptrend. Next, we connect the swing low (starting point) to the swing high (ending point) to have the fibonacci retracement levels. In this chart, you will notice there is only a 76.4% Fibonacci retracement. We don’t have another retracement level to coincide with our 76.4% Fibonacci retracement, but we do have a horizontal overlap support (green line) that lines up well with it. So based on our criteria, we have :
- Fibonacci retracement on a short term trend
- Horizontal support
- There is no Fibonacci retracement from a long term trend
Does this mean the level we highlighted which is 0.7645 is not valid? Well, it is still valid, just that personally I won’t find it strong enough when there are just 2 elements.
Let’s look at other examples :
- NZDUSD 4 hour chart
We can do 2 fibonacci retracements starting from the 2 different swing highs and ending at the swing low. As we can see, the blue and red retracement levels (dotted lines) coincides with each other, confirming that it is a key resistance level. This is a good entry for short sellers when prices reacted off that level in a downtrend.
(Combining support and resistance)
On top of that, you can see a red solid line which is our horizontal overlap resistance level. Combining our 38.2% big fibonacci retracement + our 61.8% small fibonacci retracement with our horizontal overlap resistance gives us a very strong level to sell from.
- GBPUSD 4 hour chart (resistance areas)
The first is pretty straight forward. You can see a 50% red Fibonacci retracement and a blue 61.8% Fibonacci retracement. They both coincide very nicely with each other to form a strong Fibonacci confluence resistance.
The other example is good in showing that sometimes we don’t need the levels to line up perfectly. The highlighted area in red shows 2 fibonacci retracement levels of 38% being formed near each other at a horizontal overlap resistance level. So we highlight the entire area showing that this is an area to watch out for.
- AUDUSD 4 hour chart
Taking a fibonacci retracement from 2 different starting points (swing highs) and ending at the swing low, we see that the retracement levels (red and blue dotted lines) are in line with each other, forming a fibonacci confluence.
(Combining support and resistance)
These levels also coincides with the horizontal overlap resistance confirming it is a key resistance level.
Putting it all together
Combining the fibonacci retracement levels in an uptrend and downtrend helps us to identify strong levels for trading. Remember : when you draw a fibonacci retracement, there will also many that you can pick from. The key is to find the correct ones by combining multiple fibonacci retracement levels and it is most effective when it is combined with a support or resistance level too. In our next tutorial, we will combine it further with Fibonacci extensions.
Using the example below, we can see that we have found one big 23.6% fibonacci retracement (in red) and another small 38.2% fibonacci retracement (in gold). Combining these 2 together with a horizontal overlap resistance produces a very strong resistance for our stop loss.