A Fibonacci retracement is a technical analysis tool used by traders to understand when to place and close trades or when to place stops and limits. Fibonacci retracements depend on the mathematical principles of the Golden ratio14, and they are used to find areas of resistance and support in the primary movements of assets.
To calculate Fibonacci retracement levels, traders draw six lines across the asset’s price chart: one line would be at the highest point; one would be at the lowest point, one at the midpoint and three at 61.8%, 38.2% and 23.6%. According to the golden ratio rule, these points should be the ones at which significant levels of support and resistance should be detected.
How to Use Fibonacci Retracements in Trading
Here are the steps involved in making use of Fibonacci retracements for forex and CFD trading:
1. When applying the Fibonacci tool to a downtrend, use it to the start of the move to the end (the tool is always used from the left to the right), like so:
2. With an upward moving trend, the tool should be applied at the bottom and end at the top. Once again, it is applied from the left to the right, as follows:
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Aggressively enter as the price reaches each level and place a stop loss at the other side of the Fibonacci level;
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Wait until the price finds support or resistance15 at these levels and then enter.
Fibonacci Mistakes that need to be avoided
Here are some common mistakes that even very technical traders make at times. You need to avoid these at all costs as they can mess your position and timing up:
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Do not mix your Fibonacci reference points. Keep them consistent and you should not go from a candle’s wick to a candle’s body16 as this can create a misanalysis.
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Do not ignore any long-term trends. The major mistake that new traders do is that they look at significant moves which have occurred in the short term, and this can lead to a lot of misanalyses. By looking at the long term trends, one can use the Fibonacci retracements in the right direction of momentum.
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Do not rely on Fibonacci alone as there is harm in doing this. Make use of additional analytical tools as this will increase your chances of making a good trade. You need the confirmation to allow you to move ahead.
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Do not make use of Fibonacci retracement levels over short intervals. Applying it over short intervals is quite ineffective, and it will make it difficult for the trader to decide what levels can be traded.
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