The Fibonacci retracement drawing tool can be invaluable for traders, providing the ability to measure partial reversals. This can be particularly useful in trending markets. However, the range of different retracement levels provide a variety of use cases for traders seeking to capitalise on different phases in market price action.
How to use the Fibonacci tool
The Fibonacci tool provides a series of levels which measure the percentage a market has reversed between two different points. This means that within an uptrend, traders will typically use the tool to measure the amount of the last rally that has been surrendered, with a view to another leg higher before long.
The Fibonacci tool is applied by placing the two anchor points onto the prior swing high and swing low, utilising the resulting Fibonacci levels as reference points when the market begins to retrace. It is advised to use the absolute tops and bottoms of the wicks rather than the body.
Whether or not a trader believes that the ratios derived from the Fibonacci number sequence are going to provide turning points in the market is beside the point. Markets do not move in a straight line, and thus by studying the size of each pullback, it is possible to recognise where within each market a trader is likely to see each type of pullback – shallow, medium, and deep.
Best Fibonacci trading strategies
A retracement can be any type of pullback, meaning that the specific Fibonacci levels do not need to be respected for a trader to perceive the move as a counter-trend retracement. Often the respect of those levels will tell us something about the market’s mindset and possible next move.
The shallow pullback is typically seen around the 23.6% and 38.2% level, yet it can be anything shallower too. Understandably, shallow retracements are typically seen within a highly trending or fast moving environment. When a market is moving rapidly in a given direction, we typically do not see enough support behind the counter-move, with any consolidation or pullback often fleeting. The ability to trade around such a move is crucial for situations where a market is moving quickly. Entry into a highly trending market can be difficult given the hurdles associated with setting a stop loss. Typically, it would make sense to place stop losses below the prior swing low in an uptrend, and above the prior swing high in a downtrend. Thus when a market is seeing a strong surge, traders will often jump in without considering the risk-to-reward profile or validity in the placement of their stop loss. However, it makes much more sense to enter a highly trending market within a retracement or consolidation phase. Such consolidation will often provide continuation patterns such as a pennants and flags.
However, what is important is how deep that pullback is, and where the market goes from there onwards. Should we see a shallow >38.2% retracement, followed by a break through the previous peak (uptrend) or trough (downtrend), this would be the signal to trade. The benefit of utilising this method is that it would reduce the likeliness of major losses, while also enabling substantial gains.
The chart below highlights the recent bitcoin sell-off, with a rapid deterioration followed by a shallow retracement. That sub-38.2% retracement provides the basis for a selling opportunity should we see the price break to a new low. As such, the short is opened at $5202, with a stop at $5700 (above the prior swing low). That 500-point stop loss means that we would need 1000 points downside for a 2/1 risk-to-reward (R/R) trade, which was achieved within 36 hours. However, given the possibility for greater downside, it can make sense to take part of your profit at that 2/1 target ($4200), with the rest of the position running to a more profitable target. In such an occasion, you could shift the stop loss for the remainder of the trade to either the break-even point ($5200) or 1/1 profit target ($4700).