A common question among Forex traders is whether Fibonacci retracement levels actually work and whether there is any benefit to using them. I can tell you without a doubt that they do work and they can be beneficial but only if used correctly.
In this lesson we’ll look at two ways we can use Fibonacci retracement levels as part of our trading strategy.
But I don’t want to just discuss how Fibonacci retracement levels work and how to use them. There are a myriad of sites on the internet where you can find this information. Instead I want to focus on how we can use these retracement levels in combination with the price action levels and Forex trading strategies that we’ve come to know.
So without further ado, let’s dive in!
How to Use the Fibonacci Retracement Tool
First things first, in order to understand how we can benefit from these retracement levels we first have to know how to use the tool. For purposes of this lesson I will be using MetaTrader 4, however most Forex trading platforms will have a Fibonacci retracement tool built into the platform.
The best way to illustrate how to use the tool is through real-life examples. So let’s first start with a rally where we’ll be trying to determine possible levels of support during a pullback.
GBPJPY Fibonacci Retracement Levels
Notice how in the illustration below we’re using the major swing low as a starting point and the major swing high as the end point. Although there are many swings in between, these two points are the most prominent on this chart.
This isn’t to say that you can’t use Fibonacci levels on the smaller swings, because you can. However for the way we trade the higher time frames it’s best to use the major highs and lows. You will find that, generally speaking, the more accurate Fibonacci levels are found when using a higher time frame such as the daily or weekly chart.
As soon as we drag our Fibonacci tool from the swing low to the swing high it becomes apparent that there are several well-defined levels on this GBPJPY chart.
We can now decide which of these levels are true price action levels that we want to keep on our chart. More on this later.
Notice how the 38.2, 50 and 61.8 Fibonacci levels line up with previous minor swing highs and lows. This gives us extra confidence that these are potential reaction levels where the market may reverse.
How Do Fibonacci Retracement Levels Work?
This is still a bit of a mystery. Fibonacci retracement levels have been around for a long time. The phenomena was originally discovered by an Italian mathematician by the name of Leonardo Fibonacci in the thirteenth century.
The Forex market has been around that long, you ask?
Not by a long shot. Well, I suppose some type of exchange existed, but not the Forex market as we know it today.
The truth is Fibonacci retracement levels have been adapted for use in the Forex market, but they were never intended for this use.
They were originally applied to everything from studies of the universe to defining the curvature of naturally occurring spirals, such as those found in snail shells and the pattern of seeds in flowering plants.
Yes, you read that right – snail shells and plants.
For more on how these were identified and the math behind the phenomena, see my lesson on Fibonacci retracement levels.
For this lesson just know that the most important levels are 23.6, 38.2, 50 and 61.8. Although not a true Fibonacci number, the 50% level is by far my favorite. Over the years I have found that the markets are most likely to react at this level.
Price Action and Fibonacci Levels
At this point, you should have a good understanding of how to use the Fibonacci tool and the levels to watch. Now for the really fun part – using these levels in combination with what we already know about price action. But I want to preface the remainder of this lesson with one very important point.
While Fibonacci retracement levels have their place, they should never be used alone. Don’t assume that just because a market has retraced 50% that it will react. Like anything else, Fibonacci levels are just one more confluence factor that we can add to our trading toolbox.
Now that that’s out of the way, let’s get to it!
The very best way to use the Fibonacci tool is as additional confirmation. Think of it as a second opinion. The first opinion, of course, being the price action levels you already have identified on your chart.
From what we already know about drawing support and resistance levels the following two levels are something we should already have on our chart. We can see that the market had traded between these two levels for some time and continues to react to them even today.
So now that we have our key price action levels drawn we can use the Fibonacci tool to see if any levels match. Remember, we haven’t drawn the Fibonacci levels just yet. The levels on the chart above were identified by using simple price action.
Once we draw our Fibonacci levels, it becomes immediately apparent that the 23.6 and 50 levels match up well with our price action levels we identified previously. This gives us greater confidence that any retracement to these levels should lead to an increase in demand and are therefore more likely to cause a reaction.
What if the Fibonacci levels don’t match up to our price action levels, you ask?
Not to worry. A really nice price action level will always outperform a Fibonacci level that happens to fall at an arbitrary level on a chart. Remember, think of the Fibonacci tool as a second opinion. So if your first opinion (price action level) is solid then you don’t really need a second opinion, now do you?
One last point about the chart above. If you’ll notice the 38.2 and 61.8 Fibonacci levels don’t match up to the support levels we marked as important. So should we just ignore these?
Well, here’s a tip for you. If more than one Fibonacci level lines up on a chart, chances are that the other levels are going to play a role of some importance. That doesn’t necessarily mean they will be “key” levels, but they are probably levels you should at least keep an eye on.
This can be witnessed in the chart above where the 38.2 and 61.8 levels have caused a reaction in the last few months.
Using the Tool to Find Key Levels
In addition to using Fibonacci levels as a second opinion, you can also use the Fibonacci tool to find key levels that you may have missed.
A word of caution: Use this technique of finding key levels sparingly and cautiously. Using Fibonacci levels in this manner can get you into trouble if you aren’t careful.
The first key to effectively using the Fibonacci tool in this way is to only use it on the higher time frames. My preference is the weekly time frame. However just because we’re identifying potential levels on the weekly chart doesn’t mean we have to trade the weekly chart.
Let’s take a look:
Using a GBPJPY weekly chart, we can clearly see that the 148 level is a key price action level; we don’t need Fibonacci to tell us that.
So now let’s drag our Fibonacci tool from the swing low to the swing high to see if there are any other levels that we may have missed.
The first thing we should notice is that the 50% retracement level doesn’t quite match up with the price action level we identified in the previous chart. But that’s okay! Remember that an obvious price action level will always supersede a Fibonacci level.
The next thing we want to do is to look at the 23.6, 38.2 and 61.8 levels to see if there are any other price action levels that we should pay attention to. At a quick glance, you can see that the 61.8 level may be trying to tell us something. So let’s draw a horizontal level over the 61.8 Fibonacci retracement level and find out.
Now that we have our horizontal level on the chart it’s obvious that this is a key price action level that we should pay attention to. The chart above shows how the current 61.8 Fibonacci level has impacted price action over the last several years.
Putting It All Together
At this point, we’ve covered how to use Fibonacci retracement levels as a second opinion to key price action levels. We’ve also seen how the Fibonacci tool can be used to identify key price action levels that we may have missed.
Now it’s time for the icing on the cake – finding a price action signal at a confluent level.
Let’s take a USDCAD downtrend and see if we can find a confluent level with a price action signal.
It’s pretty obvious that the 50% level lines up perfectly with recent highs on the daily time frame. Therefore we would want to mark this level on our chart and watch for bearish price action should the market rally back to this area.
Sure enough, two months later the market has rallied back to the 1.005 confluent resistance area and formed a bearish pin bar in the process.
This is a perfect example of how we can profit from using Fibonacci retracement levels combined with a simple price action strategy such as the pin bar.
One last point about the chart above. Notice where the market found support again after forming the bearish pin bar – the 23.6 Fibonacci level.
In many ways, the reason why Fibonacci levels are so effective is still a mystery. But one great thing about technical analysis is that we don’t need to figure out why something works in order to see it working and thus benefit from the results.
One thing that isn’t a mystery is that Fibonacci retracement levels work and can be extremely beneficial, but only when used properly and in combination with other trading strategies like those found with price action.
The effectiveness of this combination can be attributed to the fact that both the Fibonacci tool and price action as a trading strategy are widely used among Forex traders. Therefore the likelihood of a market respecting a confluent level becomes somewhat self-fulfilling.
We have covered a lot in this lesson, so in closing let’s recap a few key points about using Fibonacci retracement levels with price action.
- Always use the Fibonacci tool in combination with other price action strategies and techniques. Never trade a Fibonacci level blindly without other factors to help put the odds in your favor.
- Think of Fibonacci retracement levels as a second opinion to already-established price action levels
- The Fibonacci tool can be used to identify price action levels you may have missed, but use diligence in verifying that it is a true price action level
- Once a confluent area has been identified, wait for a price action signal to trade in the direction of the prevailing trend