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How to Trade with Fibonacci Retracements

Posted on April 27, 2009 by Adam

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233…

I know what you’re thinking: “Oh great, numbers! Time to click elsewhere….”

Before you do so, I think you should consider that the numbers above will make you money!

The sequence of numbers shown above are part of the famous Fibonacci series. The numbers are generated by adding the current and previous numbers together, for example, 0+1=1, 1+1=2, 2+1=3, 3+2=5, etc. The numbers in the sequence are really magical because when you divide one by another you get a constant ratio. Of course, if you are as geeky as I am, you already knew that. What you didn’t know is that that fact comes in pretty handy for trading.

When you divide a number by the next in the sequence, you get 0.618 (e.g. 144/233 = 0.618)

When you divide a number by one two positions ahead, you get 0.382 (e.g. 89/233 = 0.312)

When you divide a number by one three positions ahead, you get 0.236 (e.g. 55/233 = 0.236)

In technical analysis, those three numbers are known as the Fibonacci Retracement levels. Amazingly enough, they tend to act as pretty good support and resistance levels. It sounds pretty wacky, but it really does work. I’m a huge skeptic and that’s how I approached it at first, but then I noticed that those levels acted as magnets for price action.

So how do you apply Fibonacci retracements to your trading? The way to do it is to choose a significant high point and low point in price action and use those as your “anchor points.” Then measure the distance between the two points, multiply that number by the Fibonacci ratios, add the product to your lower anchor point, and draw horizontal lines at those price levels. Most charting packages will allow you to do this automatically nowadays, but you may want to do it by hand to fully appreciate the beauty of it.

The trick, really, is identifying significant highs and lows as your anchor points. If you choose arbitrary levels, it doesn’t really work very well. Let’s try an example. Let’s look at a chart of the S&P from about a month ago.

After the very strong reaction off of the 666 level, I was thinking about constructing a Fibonacci retracement bracket to try and figure out how prices would behave if the rally continued.

Looking at the chart, the last really significant high was at the 875 level, which the S&P tested twice before careening all the way down to 666. I decided to use it as the high and naturally, 666 (Precisely the devil’s number! I like to think the S&P went all the way to hell and back during this bear market!) as the low.

The distance between these two levels is 875 - 666 = 209 points. That would make our Fibonacci Levels:

Retracement	Price Level	Calculation
0%	666	666 + (875 - 666)*0%
23.6%	715	666 + (209)*23.6%
38.2%	746	666 + (209)*38.2%
50%	771	666 + (209)*50%
61.8%	795	666 + (209)*61.8%
100%	875	Low + (High - Low)*(Fib Ratio)

Click here to download a Fibonacci Retracements Calculator Excel spreadsheet

Let’s add these levels to our chart

We can see that the S&P has already retraced more than 23.6% of the selloff. We would expect the 23.6% retracement level (715) to act as support now that we have moved above it. The next area of resistance will come at the 38.2% retracement level (~750).

Of course, these levels may not be adhered to. If that’s the case, I try readjusting the anchor points to try and get a better fit. If you find yourself struggling to get a good fit, Fibonacci retracements probably aren’t applicable, and you shouldn’t try and force it. One thing I find interesting about this particular bracket is that the retracement levels line up with big round numbers. Thet 38.2% level is very close to 750, the 50% level is very close to 775, and the 61.8% level is very close to 800.

Let’s see how the subsequent price action confirmed or rejected these Fibonacci levels.

After breaking above the 23.6% level, prices pulled back intraday, and the level held up, as we predicted, as support.

If you were watching price action during that day, and you saw prices pull back to 715 and hold, you could try buying the market and adding long positions. It makes for a low risk bullish entry point. If the market breaks down below that level, you can exit the long trades.

On the next day, the long trade continued to work out. Prices rallied all day and ended up right at 750, which is almost exactly at the 38.2% retracement level. When prices stalled at that level, which we would expect to act as resistance, that would make a good time to exit bullish positions, since a pullback would be likely.

The rally continued, and eventually made it all the way up to 800 and pulled back, right in line with the 61.8% level resistance. This would be another good point to exit long positions. After the run to 800, prices retreated and now sit right at 768, which is right about where our 50% retracement level lies.

As smart traders, we would expect the 50% level to hold as support. I would look to buy into this market. Most likely I would add a long position or two. Let’s see what happens…

The market reacted to the 61.8% retracement level by screaming higher. Our long bets would have worked out extremely well!

I would look to continue buying if the market approaches 800, which once acted as resistance, and should act as support now that it has been broken.

Of course, the Fibonacci levels are not always adhered to precisely. I like to give them a little wiggle room. For the S&P, that amounts to about 5 points, which is why you hear me referring to the 61.8% retracement level as 800, even though it is technically 795.

To make a long story short, I like to buy when the Fibonacci levels should act as support, and sell when they should act as resistance, with some wiggle room in between. Notice that I say should. These levels don’t always work, and you need to be aware of that. What they can do is tip the probabilities in your favor. As a trader, you always want to look for edges like that.

In other words, there is no perfect way to trade. If you count on that, then you’ll end up losing time after time. But there are good ways - and this is one of them.

But why do they work?

The answer is, nobody really knows. My theory is because of how these ratios play into our natural tendencies. All artists will tell you that the most attractive shapes are those that follow Fibonacci ratios. I believe that Fibonacci retracements work because the price levels it defines are “attractive” to buyers and sellers, not to mention chartists.

And you have to account for the fact that numerous market participants all use Fibonacci retracement brackets. Since many traders pay attention to these levels, their collective behavior will actually influence price action.

FIbonacci Retracements work on any time frame

You don’t have to anchor your retracement brackets over any set time period. You can use anything from months to minutes and the same principles will apply.

In fact, one of my favorite day trading strategies is to anchor a bracket to the high and low established in the first hour of trading and use that bracket with a 5 minute chart. When the first hour high or low is broken, the next target is the first Fibonacci extension, which comes at 161.8% of the first anchor point.

Hopefully, you understand how Fibonacci retracements work and are calculated, so you can ultimately use them to trade more profitably.

Happy Trading