Last Updated on September 22, 2022 by Oddmund Groette
There are many indicators and tools for technical analysis, but only a few have leading properties like the Fibonacci tools, which is why Fibonacci trading is popular among traders. But how do you trade with the Fibonacci tool?
Fibonacci trading is the use of Fibonacci tools in making a technical analysis of a security price. The popular Fibonacci tools include the Fibonacci retracement tool, the Fibonacci expansion tool, and the Fibonacci fan. These tools are used to indicate where support and resistance are likely to occur on the chart, which helps a trader to plan his trade entry and exit accordingly.
In this post, we take a look at Fibonacci tools and how to use them.
What is Fibonacci trading?
Fibonacci trading is the use of Fibonacci tools in making technical analyses. The popular Fibonacci tools include the Fibonacci retracement tool, the Fibonacci expansion tool, the Fibonacci fan, the Fibonacci channel, and so on. These tools are used to indicate where support and resistance are likely to occur on the chart, which helps a trader to plan his trade entry and exit accordingly.
Not only can the tools be used to predict potential support and resistance levels in the market, but they also mark these levels before the market gets there. In other words, they lead the price, unlike moving averages and other indicators that lag the price. With this remarkable property, traders can anticipate what will happen ahead of time so that they can plan what to do.
Using Fibonacci in trading allows traders to analyze the market and plan for their trades ahead of time. Knowing the important reversal areas, a trader can decide when to open or close a trading position, as well as where to place stops and limits to their trades.
Let’s take a look at a few of the Fibonacci tools.
The Fibonacci retracement tool is used to the percentage of the previous price swing the price can retrace before it reverses to continue in the direction of the trend. When plotted on the price chart, the Fibonacci retracement tool draws horizontal lines at 23.6%, 38.2%, 50%, 61.8%, 100%, and so on of the preceding price swing to indicate potential support/resistance levels where a pullback may get to before reversing. Traders use these levels in their trading strategies to determine their entry point and stop loss levels.
Fibonacci expansion tool
The expansion tool traces the pullback swing and uses the size of the pullback to estimate how far the next impulse swing can expand in the trend direction. Since the tool calculates from the end of the pullback, a 100% expansion level implies that the next price swing would be the same size as the preceding one. The expansion levels can be used to estimate profit targets.
As the name implies, it fans out a series of trendlines at various Fibonacci levels, which may represent dynamic support and resistance levels. In an uptrend, the trendlines represent ascending support or resistance levels. See the chart below:
How to attach the Fibonacci retracement tool to your chart
To use the Fibonacci tool, you have to properly attach it to the right price swing. Let’s show you an example with the retracement tool. Follow these steps when attaching the tool to your chart:
- First, find out the trend direction
- Identify the most recent impulse swing when the price has started pulling back
- Pick the Fibonacci retracement tool on your charting platform and attach it to that most recent impulse swing from where it began. So, if it is an upswing in an uptrend, you start from the low to the high, but if you are dealing with a downswing in a downtrend, you start from the high to the low.
- Select the side you want the retracement levels’ values written — left or right. The tool will display horizontal lines marking the percentage retracement of that impulse swing, such that the beginning of that impulse swing would bear a 100% retracement level.
The Fibonacci retracement tool in a downtrend.
How Fibonacci levels are used in trading
There are different ways traders use Fibonacci tools in their trading, but these are the three common ways:
- Trade entry: Since the Fibonacci retracement levels show some areas of interest to watch when the price is making a pullback, traders start looking for trade signals around such levels. For example, if the RSI is showing an oversold/overbought condition when the price gets to a retracement level, such as the 61.8% level, it may be a good signal to enter a position. Price action traders look for reversal candlestick patterns, such as the pin bar or engulfing pattern, at that level. Some traders may even place limit orders at the Fibonacci levels, but this practice is risky.
- Stop loss level: Traders also use Fibonacci retracement levels to know where to place their stop loss orders. One commonly used method is to place the stop loss order beyond the 100% retracement level if the trade entry is around the 50% or 60% retracement level.
- Profit target level: Many traders use the Fibonacci expansion levels, especially the 100% expansion level, to estimate their profit targets. For those who like taking partial profits at multiple levels, the 100%, 161.8%, and 261.8% expansion levels may be good for partial profit targets.
Which timeframe is best for Fibonacci trading?
There is no best timeframe for using the Fibonacci tools in trading. The timeframe you choose depends on your trading style. If you are a day trader, you may have to use intraday timeframes. A swing trader would use the daily or 4-hourly timeframe.
Nevertheless, most technical analysis methods work better on higher timeframes, especially the daily timeframe. But the only way to know the best timeframe for your Fibonacci trading strategy is by back-testing it.
What are the best Fibonacci levels?
Various Fibonacci levels work differently in different markets. Sometimes, it depends on the market volatility. If there is little volatility, pullbacks may be short and end around the 23.6% or 38.2% levels. In markets with high volatility, pullbacks can get up to 61.8% and beyond.
Having said that, many traders prefer 50%-61.8% levels. But the only way to know the best retracement levels for your trading is from backtesting.
Is Fibonacci a good trading strategy?
There are traders who have used the Fibonacci tools in their trading strategies to great success. Will Fibonacci be a good strategy for you? No one knows; you alone can find out. The only way to find out without risking your money is to back-test the strategy and further trade it on a demo account.
Fibonacci trading strategy (backtest)
A fibonacci trading strategy is coming soon.