How to Use the Fibonacci Retracement Tool in Trading - Introduction
As a trader, you will meet many new concepts on a regular basis. You will often find traders who only believe in the concept of technical analysis and others who believe in the concept of fundamental analysis. You will meet those who believe in swing trading and others who believe in day trading. While each of these traders have different views on the market, there is one concept that has proven to be very valuable. This concept is known as Fibonacci Retracement, which can be traced to more than a century.
The concept of Fibonacci Retracement was developed using the ideas of the Fibonacci sequence. The sequence states that each number is a sum of the two numbers that precede it. As such, the sequence goes like this: 0, 1, 1, 2, 3, 5, 8… The overall formula is Xn+2= Xn+1 + Xn. By tweaking this formula, the Fibonacci retracement method can be used in the markets to help in decision making.
In the markets, the retracement tool is used to identify pivot points or areas that the price is likely to move to. This is more so useful in a trending market. To use it, you don’t need to have any knowledge on how the Fibonacci sequence works.
The first step is to visually look at a chart and see whether it is trending. A trending market is one which is moving in an upward or downward direction. If the price is ranging, it means that it is almost impossible to apply the Fibonacci Retracement tool.
Second, if the price is ranging, you need to identify areas where it is making swing highs and swing lows. After this, you need to drag the Fibonacci Retracement tool. This will result to a number of lines, which are all indicated by percentages. A good example of this is shown in the GBP/USD pair below.
After joining these lines, you each of the Fibonacci Retracement line will become a point to watch in your trading. For example, in the chart above, the GBP/USD pair is in a downtrend and the price has moved to the 61.8% Fibonacci Retracement level. The implication is that the next support level will be along the 50% Fibonacci Retracement level of 1.2900. At this level, the pair will likely find resistance as traders decide on what next. It could also come back to the 61.8% Fibonacci Retracement level and then continue moving lower.
The Fibonacci tool is not always accurate. This means that it does not always lead to positive guidelines. Instead, the tool is best-used by combining it with other indicators. Examples of other indicators that are commonly used with it are moving averages, Bollinger Bands, and Parabolic SAR. These are trend indicators, which are used in determining the direction of the asset. Others are the Relative Strength Index, Relative Vigor Index, and the Bulls and Bears Power. These are known as oscillators and are very common because they give an indication when an asset is overbought or oversold.