As discussed in our introduction to Fibonacci trading, Fibonacci analysis provides traders a way to forecast support and resistance levels and set price targets and stops. Given their popularity and widespread usage by technical analysts, it is helpful to understand the Fibonacci trading strategy. Although there are many Fibonacci ratios that traders use to determine retracement levels, the common ones are 23.6%, 38.2%, 50%, 61.8% and 78.6%. For further details on the history and mathematics of Fibonacci, you can check out our post on how the Fibonacci ratios are calculated. The decision to use a certain ratio is based on your personal preference and experience.
How to Identify Fibonacci Retracements
The Fibonacci retracement pattern can be applied to different trading markets, including stocks, ETFS, currencies, commodities, and futures. Fibonacci retracements can also be used on any time frame; however an important aspect to remember is that a Fibonacci retracement pattern on a weekly chart is more significant than one on a daily chart. For example, the below shows Microsoft stock trading at a low point of around $22 in December 2011 and it peaked to around $30 in March 2012, as indicated by the orange arrows.
To calculate Fibonacci levels, you need to take the range of two extreme points, such as a major peak and a major trough and multiply the range by a Fibonacci ratio. In this case, we would draw two lines, one at the price level of $22 and the other at $30. The line at $30 represents the 0% Fibonacci level and the line at $22 represents the 100% Fibonacci level. This means that if the price reversed at $30 and kept trending downwards towards $22, it would have retraced 100% of its prior movement.
For your information, here is how we calculate the remaining retracement levels. Let’s use $30 and $22 as the approximate prices for easy calculation.
($30 – $22) x 0.382 = 3.06
This means that the stock has retraced $3.06 of its prior advance. Subtract this amount from the peak of $30 and the price hitting this level would be around $26.94. This is represented by the 38.2% retracement level shown on our chart above.
($30 – $22) x 0.50 = 4
This means that the stock has retraced 50% of its prior advance, or down $4 from its peak of $30. This level is at a price of around $26, as indicated by the 50% retracement level line. In addition, the three green arrows show that prices actually hit this level three times.
($30 – $22) x 0.618 = 4.94
The 61.8% retracement level is at a price of around $25.
Trading the Fibonacci Retracements Pattern
Based on the above chart, Microsoft stock broke the 38.2% retracement level and continued down to the 50% retracement level, as shown by the first green arrow. It bounced back up in June, only to hit the 50% retracement level again in mid-July. At this point, the 50% retracement level is also establishing itself as a support level. Once the price bounced up again from support, some traders will use this as a signal to buy shares, while setting a stop loss just below the support level. If the support level is broken, it could signal a potential downtrend. Setting a stop loss below the support level will help to minimize potential losses.
I typically set my stop loss with a little room for false breaks. For example, there was a false break when price hit the support level the third time. The stock finally did break support later in November when there was a gap down to around $25.
Fibonacci Trading Strategy
Although many traders use Fibonacci Retracements, others argue that the Fibonacci pattern is more of an art than science. Keep in mind that technical analysis is subjective and it is an art itself. It is helpful to learn as many strategies as possible and test them to see which ones work the best for you. Many traders use multiple technical indicators to confirm a signal before making any decision.
To learn more about Fibonacci, check out this Fibonacci Trading Strategy Webinar.