A guide to using the Fibonacci tool to trade

This article highlights a number of factors traders should consider when utilizing the Fibonacci tool. From how to apply it, to how it can provide powerful trading signals.

Source: Bloomberg

The Fibonacci sequence represents a key pattern of numbers and ratios that are found in life. When these are utilised within trading, traders can look for countertrend pullbacks in similar rations. However, the tool provides a whole host of uses, that can enlighten you with powerful trading opportunities within the financial markets.

The Fibonacci tool guides to the degree to which a market moves against the trend, with each retracement level telling you a different story around the mood and sentiment within the market. Markets never move in straight lines, and it is this inability to maintain a constant directional momentum which allows for retracements. The Fibonacci retracement tool should only be used at a time when you believe that the current move is merely a retracement, rather than a reversal. That means that the price is not expected to pass through the 100% mark, instead turning back in the direction of the initial move. The use of Fibonacci levels can be particularly useful if you are a follower of Dow Theory, where a trending market is formed via the creation of higher highs/highs. In such a circumstance, a break past the 100% mark would negate the current trend in play. With that in mind, it makes sense to utilise the swing highs and swing lows that make up a trend for stop loss, and potential take profit targets.

Finding the appropriate levels to draw your Fibonacci from, can take a degree of artistry, with markets typically exhibiting trends within trends to confuse things. Essentially, look for the major turning points in the markets, with specific indecision candles often exhibited at swing highs. Look out for doji and spinning top candles, or more simply, candles with long upper or lower shadows, often turning points in the market.

The difficulty can come where you see smaller swing lows formed within the wider moves. Often, it can be beneficial to switch timeframes, to provide a greater degree of clarity. The shaded circle below highlights how the price broke through what could be perceived as a swing high, only to retrace the wider 76.4% move. 

That chart brings together a number of factors. It highlights the formation of swing highs and swing lows, which together provide us with a basis for a trend under Dow Theory. It also highlights the notion that we can often see long legged candles at those crucial turning points in the chart. However, one of the more interesting parts of this chart is that we have seen a series of deep retracements, with four consecutive pullbacks moving into the 76.4% level, before turning lower once more. This brings us to the next point, of differentiating between different Fibonacci levels.

The size of each retracement tells us a lot about the market mentality at any given time. Shallow retracements (23.6%-38.2%) often take place within confident, impulsive market moves, where counterarguments are few and far between. Bitcoin often sees such shallow moves, with confidence currently sky-high. Conversely, a deep retracement (61.8%-76.4%) can take place within a more hesitant period, such as a market reversal or consolidation. Interestingly, the example above showed a market that saw a bullish reversal upon completing a series of deep retracements. The initial wide swings in the market showed that there was enough support for the bullish side of the story, despite the overall trend moving to the downside.

If you look at utilising the previous swing high (for downtrend), or low (for uptrend) for your stop loss, then the depth of a retracement would be another measure of how far your stop loss is from entry. A wider stop loss would require a proportionately larger move in your favour to obtain a high risk-to-reward trade. That being said, a deeper retracement would provide a greater likeliness that the trend is finally going to end, given that this typically takes place in market conditions that are less confident (as mentioned above). The running theme behind the utilisation of the Fibonacci retracement tool, is the notion that a countertrend move is likely to resolve itself with a return to the overarching trend. With that in mind, there are many idiosyncrasies behind the different use cases for Fibonacci. However, while it makes sense to look at the toll as something which can provide ‘support’ and ‘resistance’, in fact it provides much more.

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