Fibonacci Retracements - Gauging a Dip in Price Part 2 In a previous post on February 19th, we highlighted 2 ways to gauge the extent of a dip in the price of a particular instrument, after a phase of upside strength. This post outlined concepts related to relatively limited and shallow corrections in price, such as those where prices are moving back down to old highs, or a 10-day moving average. You can find this report on our timeline, so please take a look.
The next challenge comes when the price of a particular instrument sees a more extended up or downside move, then the question becomes, is there anything that might aid us to gauge this type of price activity?
Technical analysts and traders will often use Fibonacci retracements as a tool to identify possible levels of support and resistance in financial markets. However, due to their calculation, these are commonly used when a more extended price move materialises.
The good news is that these are available on the Pepperstone charting system and can be utilised within any timeframe that you may wish to analyse.
Using Fibonacci Retracements:
Whether you are looking at a move to the up or downside, Fibonacci retracements can be helpful to identify support levels that may halt a price sell-off of a particular instrument within an on-going uptrend, or resistance levels that may cap any recovery within an on-going downtrend.
However, if these support or resistance levels are broken on a closing basis, they can also be useful in providing insight into whether there is an increased potential for a more sustained move in the direction of that break.
From a trading standpoint, Fibonacci retracements can provide valuable insights into market behaviour and can assist traders to make more informed decisions. The support and resistance levels they identify may be used to determine potential entry and exit points for trades, as well as areas to set stop-loss and take-profit orders for existing positions.
What to Know About Fibonacci Retracements:
Leonardo Fibonacci was a 12th century mathematician who developed the Fibonacci number sequence. Certain ratios are derived from the sequence, including 0.618, which is also known as the Golden mean. This is an important ratio that occurs throughout art, the natural world and even the human body.
Within financial markets, we use 3 set percentage retracements obtained from ratios within the Fibonacci sequence, to measure the potential extent of price declines or rallies. We use the 38.2%, the 50% (which isn’t a true Fibonacci retracement, but has become accepted by traders, as it highlights half the original move), and the 61.8%.
While there are other percentages available on all charting systems, these are the main one’s technical analysts focus on when looking at potential retracement calculations.
Downside Move: Significant High to Significant Low
In a downside move, we run the Fibonacci retracement from a significant price high to a significant price low. These are levels that stand out to you as being important extremes on the chart of the instrument you are focused on; within whatever timeframe you are analysing.
The Pepperstone charting system will then automatically calculate the 3 set percentages and provide you with 3 potential resistance areas that may cap any upside recovery in price. (See chart above).
Upside Move: Significant Low to Significant High
Within an upside move, we run the Fibonacci retracement analysis from a significant price low to a significant price high. Here the Pepperstone system will automatically calculate 3 potential support areas that may halt any downside correction in price. (See chart above).
Using Retracement Levels to Trade:
While there is no guarantee that Fibonacci retracements will identify support or resistance levels that work every time, they can offer traders levels that are worthwhile monitoring.
This can be useful if an instrument is trading within a confirmed uptrend, and we are looking to use a dip in the price as an opportunity to buy at a lower level.
Or, if an instrument is trading within a downtrend, and we are looking to use any recovery in price as an opportunity to sell at a higher level.
Traders may also use Fibonacci retracements to place stop losses just above the identified resistance level or below the support.
This is because, if for example a 38.2% Fibonacci retracement level is broken on a closing basis, it can highlight the potential of a more sustained move in the direction of the break, which could potentially be to the 50% retracement, and if this is in turn breached, on to the 61.8% level, as seen in the chart above.
In the example above, if the decline in price continued and the 61.8% support was broken on a closing basis, the Fibonacci rule suggests a more sustained phase of price weakness maybe seen towards the significant low used within the original calculation (100% retracement).
If such activity is seen within an on-going downtrend in price, the opposite is true. A sustained rally that closes above the 61.8% potential resistance, could lead to a more sustained phase of price strength towards the significant high originally identified after a downside move in price (100% retracement).
In Conclusion:
Whatever timeframe you utilise on your charts; the Fibonacci retracement can be a useful tool in highlighting support or resistance levels during a correction or recovery phase in price.
Initiating trading decisions as a retracement level is neared, can sometimes offer opportunities to establish a position before the original move is resumed. However, equally, it also allows stop losses to be placed relatively close to an entry point, as confirmed breaks of a retracement level can suggest a price moves may continue further.
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