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How to Use Fibonacci as a Research Tool for Trading

Have you used Fibonacci levels to make trading decisions? If you master the Fibonacci tool, it can help you make informed decisions when you go long or short. Here’s what you need to know.

Disclaimer: This article is an educational guide to CFD trading and the financial markets and should not be considered as advice. Trading CFDs is high risk. Always ensure you understand the potential risks and rewards associated with trading before you trade.

 

If you have been trading the financial markets using technical analysis, you might already know that Fibonacci ratios, expressed as percentages, can be a good way to follow price trends and identify support and resistance levels, as well as entry and exit positions. It is fairly easy to apply the Fibonacci tool to price action charts.

However, if you still need to master the art of reading the Fibonacci tool to make informed trading decision, here’s a quick guide to help you do just that.

1. Trading Fibonacci Retracements

Since Fibonacci retracement levels tell us the level to which an asset price is likely to pull back before continuing in the direction of the underlying trend, they can be a good way to identify support levels in an upward trend and resistance levels in a downward trend. You already know that asset prices tend to test these levels before moving forward. So, using the Fibonacci tool, you can check for these levels to determine entry and exit points for both long and short positions.

Here’s a reminder: The Fibonacci retracement level is depicted by marking the high and low price points on the chart and then marking the major Fibonacci ratios through a horizontal line to create a grid. These horizontal lines can be used to determine potential price reversal levels. The Fibonacci levels are depicted as a percentage of the total price move. For instance, if the level is placed at the mid-point between the beginning and end of the move, the retracement level is 50%. This means that the price could retrace 50% from the end of the current move, which could be used as the support or resistance level, depending on the direction of the price move.

Did you know?

The most commonly used Fibonacci levels are 38.2%, 50% and 61.8%. Although 50% is not a true Fibonacci number, it can be effective in correcting a primary or secondary price move.

2. How to Use Fibonacci Retracement Levels for Trading

Fibonacci levels are a predictive indicator that helps identify future price direction and is most effective when used in trending markets. A trade is generally placed in the direction of the ongoing trend since the expectation is that the price will bounce back from the Fibonacci level in the trend’s direction.

The idea here is to take a long position at the support identified by the Fibonacci retracement level during an uptrend and take a short position at the retracement level identified as resistance during a downtrend. The theory behind this is that once the asset price starts to move in a new direction, it is likely to return or retrace to a previous level before resuming the new trend direction.

3. How to Draw the Fibonacci Retracement Levels of a Price Chart

A. During an uptrend

  • Step 1:
    Identify the direction of the trend (uptrend in this case)
  • Step 2:
    Drop the Fibonacci tool on the bottom left of the chart and drag to the right till the highest price point
  • Step 3:
    Check for potential support levels at 0.236 (23.6%), 0.382 (38.2%) and 0.618 (61.8%)

B. During a downtrend

  • Step 1:
    Identify the direction of the trend (downtrend in this case)
  • Step 2:
    Drop the Fibonacci tool at the top left (high price) and drag to the right till the lowest price point or bottom of the chart
  • Step 3:
    Check for potential resistance levels at 0.236 (23.6%), 0.382 (38.2%) and 0.618 (61.8%)

Did you know?

Fibonacci retracement levels can be used for any timeframe, from intra-day to daily and even weekly price charts.

Fibonacci retracement levels can also be used to identify stop loss and take profit levels before opening a position to ensure effective risk management. Although these levels can be used on their own, experienced traders tend to use them as a confirmation tool, in conjunction with other indicators, such as MACD, moving averages, trend lines and volume indicators.

4. Using Fibonacci Extension Levels for Trading

Just like the Fibonacci tool is used to determine the level to which an asset price could retrace its path, it can also be used to predict the level to which the price could move in the direction of the trend or the extension level. Fibonacci extension levels are most commonly used to determine profit-taking levels or exit points.

Unlike retracement levels, extension levels are identified beyond the 100% level, with the most commonly used levels being 161.8%, 261.8% and 423.6%.

So, the Fibonacci tool can be used to determine an entry position, using the retracement levels to check for price pullbacks, and the exit position, using the extension levels to determine how far the price could move in the current direction.

Key Takeaways

  • Fibonacci ratios are expressed as percentages on a price chart to determine the size of a price move.
  • Fibonacci levels can be used to identify potential support and resistance levels, and, therefore, viable entry and exit positions.
  • Fibonacci retracement levels show the degree to which an asset price could pull back before continuing to move in the direction of an ongoing trend.
  • Fibonacci levels can also be used to determine stop loss and take profit levels.
  • Fibonacci extension levels are commonly used as profit targets since they project the level to which a price could move in the direction of the underlying trend.
  • Fibonacci extension levels can be used to identify entry positions, while retracement levels can be used to determine exit positions.

 

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