A retracement in Forex terms refers to a price correction that occurs after a period of high volatility and strong price movement in a particular direction. A retracement is a period of consolidation and is a result of large institutions closing positions and crystalising gains made from the initial price move.
Being able to calculate the extent of a retracement and determine when the previous trend will continue is a powerful tool for traders. Using Fibonacci Retracement levels to gauge retracement levels means that gains can be made trading the correction, whilst waiting for price to turn back in the direction of the trend.
The Fibonacci Golden Ratio is the key to trading a Fibonacci retracement level, and we discuss them in this article.
In This Article
- What Is The Fibonacci Sequence
- Using Fibonacci Retracement Indicator
- Trading Fibonacci Retracement Levels
- Fibonacci & Elliott Wave Theory
- Summary
What Is The Fibonacci Sequences
The Fibonacci Sequence of numbers was first identified as significant in the 13th Century by an Italian mathematician called Leonardo Pisano. The Fibonacci Sequence is a series of numbers, where each number is the sum of the preceding two and return a constant ratio of 0.618 when dividing a chosen number with the next in the series (excluding the first few numbers). The sequence of numbers continues to expand by 1.618, this is known as the Golden Ratio.
The sequence begins with 0 and 1 and continues as 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377.
If a number is divided by a number 2 places to the right, it returns a ratio of 0.382, this and the Golden Ratio are used by traders to determine to which level prices will retrace. Being able to estimate how far a retracement will extend provides a very useful piece of information for two reasons:
1) Being able to predict the likely extent of a retracement allows a trader to calculate whether placing a trade works within their trading strategy. Being able to set a take profit order at the point of which it is determined the retracement will end, means that suitable risk reward ratio's can be implemented. If the opportunity to trade the retracement meets risk management criteria, a trade can be placed.
2) If a trading strategy determines that retracements are not to traded, knowing a likely retracement level means that a trader can monitor a trade and prepare for re-entering the market as price reaches resistance.
Using A Fibonacci Retracement Indicator
The numbers in the Fibonacci sequence are themselves not used within the context of technical analysis. Fibonacci ratio's however are commonly used, particularly the Golden Ratio, in calculating a potential retracement target from a preceding trend.
The above screenshot from a EUR/USD 8hr technical chart shows the Fibonacci retracement indicator being overlaid onto a previous downward impulse wave and connects the start of the impulse wave to the end. The Fibonacci retracement tool automatically plots the chosen key levels. The extract above shows only Golden Ratio for chart clarity, but in reality the broker software will have options to include additional ratio's that suit the traders needs. By way of example, other levels sought by prices include 23.6%, 38.2%, 50% and 76.4% but the technical indicator can be edited by the user as they see fit.
The above extract is a perfect example of the effectiveness of using Fibonacci retracement tools, it demonstrates how the indicator provides an easy to identify point of resistance at the 0.618 ratio before resuming the downtrend. If a short position is to be entered at the 0.618 resistance level, it would be good practice to set a stop loss order just above entry.
Trading Fibonacci Retracement Levels
Many successful traders will tell you that the "trend is your friend" and trading the trend is a less risky form of trading as it provides higher probability trading opportunities. Looking back at the chart above, it is clear that the trend prior to the retracement was bearish. When the retracement commenced, traders with a short position will have exited their positions and capitalised on profits already made. Having a trend following strategy would prevent re-entry until the downtrend resumed, the Fibonacci retracement indicator provides a potential re-entry point into a short position.
It is important to remember that when trading, nothing is an exact science! When price points approach Fibonacci retracement levels, other technical indicators should be used to confirm the strength of the ratio. When there is momentum shift in buying pressure to selling for example, or visa versa, the Relative Strength Index will provide overbought or oversold readings, there will also often be changes in trading volume, or the development of significant candlestick patterns.
Fibonacci & Elliott Wave Theory
Elliott Wave theory is widely used in technical analysis to explain historical price movements in the Forex markets and to predict future trading opportunities. The theory claims that prices move in waves, with each wave representing a particular moment within a rhythmic, regular and repetitive pattern that reflects group psychology and market sentiment. The infinite repetition of the Elliott Wave pattern means that traders are able to reliably predict the next pattern.
Elliott Wave theory works by identifying and counting wave patterns. Corrective waves, or retracements, form an integral part of the wave pattern, but can be difficult to count as they form during periods of consolidation and uncertainty that can last long periods of time. During these periods, prices can often stagnate and the lack of trading volume reduces momentum, making corrective waves more difficult to track.
An Elliott Wave trader will often look at Fibonacci retracement ratios as a method for counting corrective waves. Due to the varied formations and time frames that corrective waves can form, they can be extremely difficult to count. Many Elliot Wave traders will use the Fibonacci retracement tool as confirmation of their count.
A key difference for EWT traders is determining the beginning and end points from which the retracements are calculated. We have previously discussed connecting the highs and lows of the previous trend to calculate retracements, but Elliott Wave traders must plot the beginning and end of the previous wave that is being retraced, which may not always be the same.
Summary
Retracements are a fundamental characteristic of trading as prices consolidate to reflect value. Trading retracements can be a strategy in its own right, either trading the retracement itself, or identifying a likely price target looking to re-enter a position in the direction of the longer term trend. Being able to identify the likely price point at which the momentum of a retracement is likely to wain, is essential for establishing entry & exit points along with stop loss and take profit limits.
