It is amazing how the financial market follow the support and resistance levels of seemingly arbitrary technical indicators. The mere fact that markets often pull back to Fibonacci retracement levels and rally to its extensions, should cause traders to sit and take note that they have tremendous value as legitimate trading tools.
Identifying Fibonacci Retracement Levels
In essence, Fibonacci retracement technical analysis seeks to determine, or forecast, how much of the original move a trade instruments will pullback before it continues the original move or trend; these are know as the Fibonacci retracement or support levels. These levels can be identified by drawing a trend line from the high and low point of the move, and then dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50% and 61.8%, see figure1.
Assuming that the retracement levels are drawn properly, the technical analysis strategy can be used to identify good trade entry points.
Identifying Fibonacci Extensions Levels
While the Fibonacci retracement levels identify good entry points, Fibonacci extensions identify all significant levels beyond the highs (for bullish moves) and low (for bearish moves). These are the levels that traders often use as profit targets. The most popular extension levels are 161.8%, 261.8% and 423.6%, see also figure 1.
Applying the Fibonacci Technical Indicator
To successfully draw the Fibonnacci extensions, traders will need to first identify the market direction and secondly, the previous high and lows. Once the highs and lows of the price move have been identified, use the Fibonnacci tool to draw a line from the start of the move to the point where it ends. Most charting software should do the rest and calculate all the relevant retracement and extension levels.
The Fibonacci trading system seem to work best in determining possible profit targets, after the market has completed a significantly and decisive move. Figure 1 shows that the market had rallied from point A to B, and then started to retrace. Notice that the market then retraces to point C before rallying to the Fibonacci extension at D.
Fibonacci trading strategies are a good way to identify low risk high reward trade entries. The idea is to buy as low as possible (at point C), and set the profit targets at point D. In addition, the stop loss is set just below point A, just in case the market doesn’t resume its previous move, or finds support at point A.
Often the market allows for a good, low risk, entry by pulling back from the previous move. Typically this happens when day traders close their open positions at the end of the day or take some profits off the table. After the price moves are complete, Fib retracements often show up as wave patterns on price charts. A good Fibonacci trading strategy allows the trader to ride each wave by identify where each wave is likely to start and where it will probably end.
A Forward Looking Technical Indicator
Unlike most indicators, the Fibonacci technical indicator is a forward-looking indicator. This means that it gives traders a forecast of what is likely to happen in the near future. Whereas other indicators, like the MACD and Stochastic, only help to interpret what has already happened. In some cases they may indicate what may happen next but not in the way the Fibonnacci predicts retracements (entry points) and extensions (profit targets).
The Fibonnacci technical indicator is one of those powerful trading tools that can accurately identify profit targets long before the market moves to those levels -- consider making it a part of your trading strategy.
Steve McFarlane - I am a professional freelance writer who is passionate about bringing quality and relevant content to my audience of readers. I strive to ...
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