Fibonacci retracements are super useful for identifying key support and resistance levels in a trending market. Ideally, we use it to buy in an uptrend and sell in a downtrend. 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. Any time frame can have a trend, albeit it can be either a short term one or a long term one. Despite knowing it’s usefulness, many people are unable to draw fibonacci retracements correctly. The main difficulties is in identifying the starting and ending points to draw these from – and this is what we’ll cover today in this intensive course on Fibonacci retracements.
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, mainly :
- 76.4% or 78.6%
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 trend – prices going down or up?
- Identify recent swing lows and highs
- Connect the 2 extreme points – highest to lowest (downtrend), lowest to highest (uptrend)
- Find levels that coincides with horizontal support or resistance lines
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.
However, if there are bars on the right that ‘break’ it, it becomes invalid. Here’s an example :
Now that we’ve clarified that issue on the rules of drawing FIbonacci retracements, let’s take a look at some examples below. The simple fact is : YOU WILL ALWAYS FIND FIBONACCI RETRACEMENT LEVELS. DON’T USE ALL OF THEM.
You have to be very picky of the Fibonacci retracements 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.
(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 (red) fibonacci retracement + our 61.8% small (blue) 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 above, 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.
So in summary, there are a few things you need to know before you start drawing fibonacci lines. Firstly, you have to identify correctly where your starting and ending points are. Always remember that you’re looking for extreme swing highs and lows to draw them from. Short of a better word, you’re looking for dramatic swing highs and lows. Remember that there shouldn’t be any bars on the right of your swing starting and ending points that “break” the level (refer to the first and second image in this tutorial to get a better understanding). Secondly, when you draw a fibonacci retracement, there are going to be a lot of levels. NOT ALL LEVELS ARE VALID. You have to find the level which is the most valid. To do this, we usually look for these 3 elements to line up :
- 1 x Fibonacci retracement (short term)
- 1 x Fibonacci retracement (long term)
- 1 x Horizontal support / resistance
Having all 3 line up nicely at a specific level is always a good sign that there is confluence at that level and it’s a strong level to trade off. In our next tutorial, we’ll look at how to do Fibonacci extensions which are even tougher than Fibonacci retracements. But when combined together, they provide a killer strategy.
Now that you’re done with learning how to draw Fibonacci retracements correctly, let’s go on to the next stage of learning how to draw Fiboancci extensions properly.