Trading Using Retracements back up to a Notable Price Level

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Start ‘Charting’ Your Path to Profits With the 50% Retracement Rule

Learn how uncover fantastic buying opportunities

Since early March, demand has been in control of the stock market, and this trend is set to continue for the intermediate term (i.e., weeks to months).

To stay ahead of the market curve, I’ve been reducing bullish exposure lately, as I have seen signs of weakness in the stock market. But, nonetheless, demand is still in control until further notice. So, if there are some stocks that you want to take a bullish position in, you might be asking yourself when the best time to buy would be.

You Don’t Have to Wait for a Bull Market to Be a Buyer

First of all, what you want to do, if you are going to be bullish, is to buy the strongest stocks within the strongest sectors — but you want to buy them on a pullback.

But, how do we know how much a stock is going to retreat before its next advance?

There are a number of ways to predict a stock’s behavior, most having to do with past support levels.

A stock’s support level is exactly what it sounds like — a floor through which the stock has trouble breaking. The opposite term is resistance, which is a ceiling through which a stock has difficulty penetrating. When a stock is trading between these two levels, it is said to be in a trading channel.

I have a number of simple indicators that I use to decide what to trade and when, some of which come in the form of popular moving averages and trendlines.

But today I’m going to go over one of the most basic “technical analysis 101” principles that will lay down a foundation for understanding how far a stock is likely to retreat before the next bull run.

Don’t forget, these are just the basics, but knowing them will help increase your accuracy, especially when you consider the following principle in conjunction with identification of past support and resistance levels.

The Secret is Not So Secret After All — Just Trade the Trend!

Bottom line, you always want to trade in the direction of the trend. And a trend is obviously a series of zig-zags. These zig-zags move in the direction of the trend and then retrace before continuing in that same direction. (Like I said, it’s technical analysis 101.)

The 50% Retracement Rule

While secondary parameters are set at 33% and 66% (as outlined in the chart above), the most-common percentage retracement before resumption is the (approximately) 50% retracement.

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I know, this might sound absolutely crazy if this is your first time hearing it, but if you look at a bunch of stock or index charts after reading this article and apply these percentage retracement principles, you’ll be absolutely amazed!

Two Steps Forward, One Step Back

The way that traders use this application, for example, would be to look for approximately a 5-point retracement after a stock advances by 10 points from a low to a new high (because 5 points is 50% of the 10-point gain).

So, when a stock trades 10 points higher from $15 to $25 and then reverses lower, traders would look for support around $20.

Again, this is certainly not a strict rule, and the secondary parameters wouldn’t have been set near 33% and 66% if it were. In fact, other theories set retracement parameters around 62% and 38%, while maintaining the 50% point as the average retracement.

Secondary Parameters

When it comes to retracements, 66% is a critical area. For instance, in the case of an uptrend, if a stock advances higher, and then retraces 66% of the recent move and starts to bounce higher again, it’s considered to be a relatively low-risk buying opportunity.

But if the 66% retracement area is violated (if the stock retraces by more than 66%), a reversal of the prior uptrend is very likely.

This is also true in the case of a downtrend, so listen up if you are looking for a good place to enter bearish positions to take advantage of the next downtrend in the general stock market. (Learn How to Pick the Right Put Option.)

If a downtrending stock retraces about 66% of the recent decline and begins to resume its downtrend, that area is a good place to sell short the stock or buy put options. If the downtrending stock retraces more than 66% of the recent decline, then the downtrend is likely to reverse to an uptrend.

In ‘Support’ of Trading on Retracements

Let’s take a look at how to find retracements, which can serve as fantastic buying opportunities.

  • The stock moves from about $2.20 to about $3.50 (not counting intraday movements). This is a $1.30 advance, half of which is 65 cents. The stock retraced by about 60 cents. (This retracement also coincided with the gap higher, which tends to act as the new support level.)
  • The stock then moves from about $2.90 to $3.25 (a 35-cent move). Fifty percent of that is 17.5 cents. The stock retraced by nearly that amount before moving higher.
  • Then focus on the blue box. You can see that after a 50% pullback, the stock gapped even lower, and the trend reversed from an uptrend to a downtrend.
  • Between August and September, the stock traded from about $2.60 to $3.20 (a 60-cent move), followed by a retracement of about 30 cents.
  • Then, if you check out the blue line, the intermediate move was from $2.90 to about $4.20 (a $1.30 move), followed by a retracement of nearly 65 cents.
  • If you look at many of the short-term retracements and resumptions within the intermediate move (blue line), you’ll see similar action.

This chart happens to have lots of 50% retracements. But remember the secondary parameters, and try to match them with past established support or resistance levels to estimate retracements.

And remember, this is a very basic principle. I thought I would give you something today that was far from complex. The good news is that other, more “sophisticated” parameters that traders look for are just as easy to understand!

Using Fibonacci Retracement Levels with Price Action

A common question among Forex traders is whether Fibonacci retracement levels actually work and whether there is any benefit to using them. I can tell you without a doubt that they do work and they can be beneficial but only if used correctly.

In this lesson we’ll look at two ways we can use Fibonacci retracement levels as part of our trading strategy.

But I don’t want to just discuss how Fibonacci retracement levels work and how to use them. There are a myriad of sites on the internet where you can find this information. Instead I want to focus on how we can use these retracement levels in combination with the price action levels and Forex trading strategies that we’ve come to know.

So without further ado, let’s dive in!

How to Use the Fibonacci Retracement Tool

First things first, in order to understand how we can benefit from these retracement levels we first have to know how to use the tool. For purposes of this lesson I will be using MetaTrader 4, however most Forex trading platforms will have a Fibonacci retracement tool built into the platform.

The best way to illustrate how to use the tool is through real-life examples. So let’s first start with a rally where we’ll be trying to determine possible levels of support during a pullback.

GBPJPY Fibonacci Retracement Levels

Notice how in the illustration below we’re using the major swing low as a starting point and the major swing high as the end point. Although there are many swings in between, these two points are the most prominent on this chart.

This isn’t to say that you can’t use Fibonacci levels on the smaller swings, because you can. However for the way we trade the higher time frames it’s best to use the major highs and lows. You will find that, generally speaking, the more accurate Fibonacci levels are found when using a higher time frame such as the daily or weekly chart.

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As soon as we drag our Fibonacci tool from the swing low to the swing high it becomes apparent that there are several well-defined levels on this GBPJPY chart.

We can now decide which of these levels are true price action levels that we want to keep on our chart. More on this later.

Notice how the 38.2, 50 and 61.8 Fibonacci levels line up with previous minor swing highs and lows. This gives us extra confidence that these are potential reaction levels where the market may reverse.

How Do Fibonacci Retracement Levels Work?

This is still a bit of a mystery. Fibonacci retracement levels have been around for a long time. The phenomena was originally discovered by an Italian mathematician by the name of Leonardo Fibonacci in the thirteenth century.

The Forex market has been around that long, you ask?

Not by a long shot. Well, I suppose some type of exchange existed, but not the Forex market as we know it today.

The truth is Fibonacci retracement levels have been adapted for use in the Forex market, but they were never intended for this use.

They were originally applied to everything from studies of the universe to defining the curvature of naturally occurring spirals, such as those found in snail shells and the pattern of seeds in flowering plants.

Yes, you read that right – snail shells and plants.

For more on how these were identified and the math behind the phenomena, see my lesson on Fibonacci retracement levels.

For this lesson just know that the most important levels are 23.6, 38.2, 50 and 61.8. Although not a true Fibonacci number, the 50% level is by far my favorite. Over the years I have found that the markets are most likely to react at this level.

Price Action and Fibonacci Levels

At this point, you should have a good understanding of how to use the Fibonacci tool and the levels to watch. Now for the really fun part – using these levels in combination with what we already know about price action. But I want to preface the remainder of this lesson with one very important point.

While Fibonacci retracement levels have their place, they should never be used alone. Don’t assume that just because a market has retraced 50% that it will react. Like anything else, Fibonacci levels are just one more confluence factor that we can add to our trading toolbox.

Now that that’s out of the way, let’s get to it!

The very best way to use the Fibonacci tool is as additional confirmation. Think of it as a second opinion. The first opinion, of course, being the price action levels you already have identified on your chart.

From what we already know about drawing support and resistance levels the following two levels are something we should already have on our chart. We can see that the market had traded between these two levels for some time and continues to react to them even today.

So now that we have our key price action levels drawn we can use the Fibonacci tool to see if any levels match. Remember, we haven’t drawn the Fibonacci levels just yet. The levels on the chart above were identified by using simple price action.

Once we draw our Fibonacci levels, it becomes immediately apparent that the 23.6 and 50 levels match up well with our price action levels we identified previously. This gives us greater confidence that any retracement to these levels should lead to an increase in demand and are therefore more likely to cause a reaction.

What if the Fibonacci levels don’t match up to our price action levels, you ask?

Not to worry. A really nice price action level will always outperform a Fibonacci level that happens to fall at an arbitrary level on a chart. Remember, think of the Fibonacci tool as a second opinion. So if your first opinion (price action level) is solid then you don’t really need a second opinion, now do you?

One last point about the chart above. If you’ll notice the 38.2 and 61.8 Fibonacci levels don’t match up to the support levels we marked as important. So should we just ignore these?

Well, here’s a tip for you. If more than one Fibonacci level lines up on a chart, chances are that the other levels are going to play a role of some importance. That doesn’t necessarily mean they will be “key” levels, but they are probably levels you should at least keep an eye on.

This can be witnessed in the chart above where the 38.2 and 61.8 levels have caused a reaction in the last few months.

Using the Tool to Find Key Levels

In addition to using Fibonacci levels as a second opinion, you can also use the Fibonacci tool to find key levels that you may have missed.

A word of caution: Use this technique of finding key levels sparingly and cautiously. Using Fibonacci levels in this manner can get you into trouble if you aren’t careful.

The first key to effectively using the Fibonacci tool in this way is to only use it on the higher time frames. My preference is the weekly time frame. However just because we’re identifying potential levels on the weekly chart doesn’t mean we have to trade the weekly chart.

Let’s take a look:

Using a GBPJPY weekly chart, we can clearly see that the 148 level is a key price action level; we don’t need Fibonacci to tell us that.

So now let’s drag our Fibonacci tool from the swing low to the swing high to see if there are any other levels that we may have missed.

The first thing we should notice is that the 50% retracement level doesn’t quite match up with the price action level we identified in the previous chart. But that’s okay! Remember that an obvious price action level will always supersede a Fibonacci level.

The next thing we want to do is to look at the 23.6, 38.2 and 61.8 levels to see if there are any other price action levels that we should pay attention to. At a quick glance, you can see that the 61.8 level may be trying to tell us something. So let’s draw a horizontal level over the 61.8 Fibonacci retracement level and find out.

Now that we have our horizontal level on the chart it’s obvious that this is a key price action level that we should pay attention to. The chart above shows how the current 61.8 Fibonacci level has impacted price action over the last several years.

Putting It All Together

At this point, we’ve covered how to use Fibonacci retracement levels as a second opinion to key price action levels. We’ve also seen how the Fibonacci tool can be used to identify key price action levels that we may have missed.

Now it’s time for the icing on the cake – finding a price action signal at a confluent level.

Let’s take a USDCAD downtrend and see if we can find a confluent level with a price action signal.

It’s pretty obvious that the 50% level lines up perfectly with recent highs on the daily time frame. Therefore we would want to mark this level on our chart and watch for bearish price action should the market rally back to this area.

Sure enough, two months later the market has rallied back to the 1.005 confluent resistance area and formed a bearish pin bar in the process.

This is a perfect example of how we can profit from using Fibonacci retracement levels combined with a simple price action strategy such as the pin bar.

One last point about the chart above. Notice where the market found support again after forming the bearish pin bar – the 23.6 Fibonacci level.

Summary

In many ways, the reason why Fibonacci levels are so effective is still a mystery. But one great thing about technical analysis is that we don’t need to figure out why something works in order to see it working and thus benefit from the results.

One thing that isn’t a mystery is that Fibonacci retracement levels work and can be extremely beneficial, but only when used properly and in combination with other trading strategies like those found with price action.

The effectiveness of this combination can be attributed to the fact that both the Fibonacci tool and price action as a trading strategy are widely used among Forex traders. Therefore the likelihood of a market respecting a confluent level becomes somewhat self-fulfilling.

Key Points

We have covered a lot in this lesson, so in closing let’s recap a few key points about using Fibonacci retracement levels with price action.

  • Always use the Fibonacci tool in combination with other price action strategies and techniques. Never trade a Fibonacci level blindly without other factors to help put the odds in your favor.
  • Think of Fibonacci retracement levels as a second opinion to already-established price action levels
  • The Fibonacci tool can be used to identify price action levels you may have missed, but use diligence in verifying that it is a true price action level
  • Once a confluent area has been identified, wait for a price action signal to trade in the direction of the prevailing trend

Your Turn

Are you currently using Fibonacci retracement levels as part of your Forex trading strategy? Share your experience with Fibonacci levels in the comments section below.

I look forward to seeing your comment or question.

Leave a Comment:

14 comments

Hi Justin, I love this Fibonacci lesson, I make use of the Fibonacci on the H4 and with this lesson on combining it with price action (already drawn support and resistance) to confirm, is wonderful.
However, I have three problems:
1. Long wicks always take out my stop loss and then proceed in the direction i predicted it to go, that’s really disappointing, please how do i avoid it?
2. How or where do I place my take profits, using the Fibonacci.
3. How should I Draw Support and Resistance zones?
Thank You, Your Lessons are a great help

1. Trade from the daily time frame and forget anything lower.
2. Use the levels the market gives you. Fibonacci tool should only be used to confirm such levels.
3. Start with the major swing highs and lows on the daily and refine as necessary.

Thank you for sharing such great info for free they work perfectly iv learnt a lot from your site when i have enough money i must fly from South Africa to where ever you are to thank you in person.

If price is running
How can I know recently high of running market

Thanks Justin, valuable info, before I started with PA trading, I religiously believed in trading FIBO’s and Daily Pivots, well, needless to say, intraday trading and scalping was not for me. since then PA trading which fits me like a glove.

I chucked all indicators, trading pure price action, on a clean chart. but after reading this, I can surely see that FIBO retracement will further sharpen the decision making, exact entry point as a second confirmation

Thanks for all the advice

Thank Justin very effective indeed

You’re welcome. Glad to hear that.

lights are on and bells are ringing…. why didnt I see this with FIB before…thanks Justin

You’re welcome, Martin. Let me know if you have questions.

Thank you for this wonder lesson, I will leverage on it.

You’re very welcome.

Very helpful lesson. However I have a question. I am an intraday trader. So should I draw Fibonacci every day or should I construct it on daily or weekly chart and use it every day?

do you have any courses that briefly educate us from these tools. may be an online course

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Fibonacci and trading. How to trade on the exchange using Fibonacci retracement levels.

If there are ratings of the most popular instruments for analysis, Fibonacci retracement levels are in all of them. We are sure in it. Great traders speak about them in their interviews. Recently, we even discussed a Forex trading strategy based on Fibonacci numbers and Elliott waves. Today we publish an expanded article about significance of Fibonacci numbers in trading.

Read in this article:

  • who Fibonacci is and where Fibonacci numbers came from;
  • what CFA and EWA are;
  • correction and retracement levels;
  • internal correction patterns;
  • extension levels;
  • projection levels;
  • Fibonacci zones;
  • Fibonacci retracement levels and footprint;
  • additional literature about CFA.

We will use the market of gold futures as an example in this article, but you can, as well, apply Fibonacci retracement levels in any other market with any timeframe.

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Who Fibonacci is and where Fibonacci numbers came from.

The mathematician Leonardo of Pisa lived in the 13th century and was one of the most famous scientist of his time. The Fibonacci name was derived from two words ‘filius Bonacci’ (son of Bonacci), written on the cover of the most famous work of Fibonacci – ‘Book of Calculation’. Sequence of numbers, which we call now Fibonacci numbers, originates from the problem about rabbits. Leonardo tried to solve the problem about how many rabbit pairs would be inside a fenced area in 12 months from the beginning of reproduction, if there is only one pair in the beginning of the process.Starting from the third month rabbits reproduce recurrently, which means that every subsequent number equals the sum of the previous two numbers: 0,1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233 and so on to infinity. By the way, if you are still wondering how many rabbits would be in 12 months, the answer is 233 pairs.

We have a pair of questions after this historical excursus:

  • why Fibonacci studied rabbits;
  • how the results of the experiment with rabbits could be used in trading.

In fact, the mathematician Fibonacci was not interested in agriculture and didn’t plan to breed rabbits. He systemized knowledge of ancient Greeks and Indians in his ‘Book of Calculation’, introduced Arabic numbers and multiplication and analyzed various mathematical problems, including the one about rabbits. If we divide any number in the sequence by the previous number, we will get the number, which tends to 1.61803398874… This number is called ‘the golden ratio’, ‘Divine Proportion’ or one of the treasures of geometry. It attracted interest before Fibonacci. It is called by the Greek letter ‘phi’ in algebra .

1:1 = 1.0000 which is lower than phi by 0.6180
2:1 = 2.0000 which is higher than phi by 0.3820
3:2 = 1.5000 which is lower than phi by 0.1180
5:3 = 1.6667 which is higher than phi by 0.0486
8:5 = 1.6000 which is lower than phi by 0.0180

If any number in the sequence is divided into the subsequent one we get the number, which is reciprocal of phi 1.618 (1:1.618) or 0.618. If we divide any number in the sequence by the number, which goes after the subsequent number in the sequence, we get 0.382. Here we found Fibonacci numbers in the form, which is familiar for traders.

What CFA and EWA are

EWA is the Elliott Wave Analysis. Fibonacci retracement levels are closely connected with the Elliott Wave Theory, because Fibonacci numbers are used for assessment of the wavelength.

CFA is the Comprehensive Fibonacci Analysis. It emerged as independent of Wave Analysis for global markets with high volatility. Price corrections are mainly used in the Forex market for trading by CFA. Further on, we will consider CFA instruments: Fibonacci correction, projection and extension levels. The main idea of using CFA instruments is to find a level, from which the price would reverse. The instruments are used both individually and jointly. It is very important in CFA to build any Fibonacci retracement levels correctly, that is correctly identifying beginning and end of a level.

Correction and retracement levels.

Correction or retracement is a movement against an existing trend. Correction ‘eats’ a part of the trend movement. The following Fibonacci numbers are most often used for the correction levels:

Correction levels are built by candle shadows, that is by their high and low points. You need to find a trend, first, in order to build a correction level. All traders build trend lines differently – there is more creative activity in it than a systematic approach. If you have doubts, the ZigZag pro indicator will help you to identify the upper and lower points of a trend line. Since Fibonacci retracement levels could be unsymmetrical, pay attention to where the wave, by which you build levels, starts and ends. In case the trend is descending, there is 0% in the bottom and 100% on top. And it is vice versa if the trend is ascending. If someone gets confused with sides or used to build correction levels always in one direction, the trading and analytical ATAS platform can arrange mirror reflection of levels in one click.

Example. Let’s build correction levels in 10-minute E-micro Gold futures (MGCM9) chart.

We used ZigZag pro with the 40 ticks setting for identifying the trend. If you do not know what indicator settings should be used, watch this video on our channel. The trend correction in our chart ends in point 1 after deviation from the high by 38.2%.

The most significant correction level is 61.8. A new trend starts, as a rule, in the opposite direction, when this level is broken, and it is necessary to build a new correction level.

Internal correction patterns.

The correction pattern is a movement between insignificant correction levels, after which the price, most often, moves to the key level of 61.8. There are 4 patterns depending on namely what correction levels are touched by the price. We will not discuss all patterns in detail. We will show one example, which is called IP2 or price movement between the 38.2 and 14.6 levels. Theoretically this pattern looks as follows:

Real-life example in an hourly E-micro Gold futures (MGCM9) chart.

We again built trend lines with the help of the ZigZag pro indicator with 100 ticks setting. The price touched the level of 38.2 in points 1 and 2 and bounced to the level of 14.6. This pattern warns us that the price, most probably, would move to the level of 61.8, which we see in point 4. The level of 61.8 is a key level. The previous trend is broken when this level is broken.

Extension levels.

Extension is a movement towards an already existing trend.

For example, here are the numbers, which are used for extensions by Derrik S. Hobbs, the author of the ‘Fibonacci for the Active Trader’ book:

There are two types of extensions. The first type means additional levels, where the price may reverse. The second type means the zone between additional levels, inside which the price may stop and reverse.

We added extension levels of blue colour to the correction levels in the following 10-minute E-micro Gold futures (MGCM9) chart.

The price reached the extension level of 127.2 in point 1 and bounced back.

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