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Understanding Fibonacci Retracement Levels

Understanding Fibonacci Retracement Levels

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Fibonacci retracement levels are derived from the Fibonacci sequence where each included number is the sum of the previous two. Fibonacci retracements are used in forex trading to anticipate future price movements and potential direction. It is a common indicator used in technical analysis that analyzes price action in order to identify possible support and resistance levels price will likely encounter.

Understanding Fibonacci Retracement Levels

Fibonacci retracement levels are horizontal lines that indicate where price could potentially reverse its direction by pointing out possible support and resistance levels for the current move. Fibonacci retracements are used as a confirmation signal that is best applied alongside other technical indicators such as the moving average convergence divergence (MACD), moving averages and trendlines. The more correlated all indicators are, the stronger the signal is.

Fibonacci levels are proved to be more effective in a trending market where the levels act as a support where buyers go long when prices are trending up, or resistance levels where traders go short when the market is trending down. The indicator works as a predictive tool that attempts to identify where the price may be heading next. Fibonacci retracement levels are also used to measure how far prices will move against the current trend. They are drawn between the higher peak and lowest dip in a certain market movement to assess the continuity of a price pullback.

Fibonacci sequence is a mathematical pattern that starts with zero and one, every following value is a sum of the previous two values as in 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377 and so on to infinity. It is credited to the Italian mathematician, Leonardo Fibonacci, who introduced the Hindu-Arabic numeral system to Europe in the Middle Ages as well as introducing a sequence of figures that are known as the Fibonacci sequence.

The sequence actually is very interesting on both theoretical and physical levels. It has been proved integral for maintaining balance in architecture, nature and financial markets.

The Golden Ratio – Fibonacci sequence is focused on the ration between the numbers in the sequence. Any number when divided by the previous one will always be approximately equal to the magic number 1.618. This is what’s known as the golden ratio.

In trading, the most popular Fibonacci retracement levels are 23.6%, 38.2%, 61.8%, and 78.6% as they allow traders to identify to what extent the price will go before retracing so they can position for the trade. 50% is also used as a retracement level although it is not an official level. These levels are used as support and resistance levels in addition to identifying upward and downward trends. There is another indicator known as Fibonacci extension, which is a continuation pattern.

How Fibonacci Retracement Levels Work in Forex

As mentioned, Fibonacci levels are often used as support and resistance levels where a correction move either reverses and price continues in the main direction, or it continues and confirms the new trend. When prices move in a certain direction, traders may use these levels as targets. So, when the price approaches 38.2% and breaches it, traders expect the current move to extend to the next level which is 50% followed by 61.8%. 

While the 23.6% is comparatively shallow and can be only suitable as a signal for breakouts or short-term pullbacks, the 61.8% level is commonly known among traders as the strongest and the confirmation level of the continuity or reversal of the recent price movement. It represents the golden ratio. Meanwhile, 38.2% and 50% levels are considered as a moderate correction.

How to Draw Fibonacci Retracement Levels on Chart

In a trending market, the counter-trend moves are known as pullbacks. Fibonacci retracement levels highlight the potential reversal area and therefore identify the potential entry and exit points after a pullback. It can be applied both after an uptrend or a downtrend to show reversal levels in the direction of the prior trend.

  1. Identify whether the market is in an uptrend or a downtrend.
  2. In an uptrend, draw the Fibonacci levels from the start of the up movement (lower bottom) and drag it up to the peak of the move.
  3. In a downtrend, draw the Fibonacci levels from the start of the down movement (higher top) and drag it down to the lowest bottom of the move.
  4. Watch for 23.6%, 38.2%, 61.8% as support levels in the uptrend and as resistance level for a downtrend.
Understanding Fibonacci Retracement Levels

Price reversal or continuation near Fibonacci levels can be confirmed with the aid of other indicators and candlestick patterns. Trading based on Fibonacci retracements is not enough, it is a confirmation indicator and should be used among other forms of technical analysis.

Fibonacci retracement levels are commonly used to identify reversal areas of a price pullback within a trend. Due to their high accuracy in detecting reversal points, Fibonacci retracements are widely seen as a powerful analytical tool that is applicable to different strategies and instruments.

Fibonacci Retracement on MT4

You can easily use Fibonacci retracement levels on your Metatrader 4 (MT4). At the top menu, click on the highlighted icon, draw Fibonacci levels on the chart by connecting the high and low of a specific move, and levels will automatically appear on the chart.

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Understanding Fibonacci Retracement Levels

Sharpen your Skills With our Educational Guides

Learn more about forex technical analysis and enhance your trading experience through our educational resources:

  1. The Beginner’s Guide to Forex Technical Analysis
  2. Trend Analysis Explained: How to use Trends in Forex Trading
  3. Top Technical Indicators Used in Forex Trading

The use of technical indicators may vary depending on the trading strategy followed. Explore different trading strategies and choose the best type of analysis that suits your personality and trading goals.

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