How to Use the Fibonacci Retracement Tool in Your Day Trading Strategy

Article was originally posted here

I keep getting questions about advanced and complex technical indicators like Fibonacci retracements.

What I’m about to write might come across as a little weird, but here goes …

I don’t use most of these ‘super advanced’ technical indicators in my trading. It’s not that I don’t respect them. Nor do I think they are completely worthless. For some traders, these indicators are really important. It’s part of their trading strategy. Which is why you should understand them.

Remember, there are winners and losers in every trade. Your goal is to be on the winning side often enough to grow your account. Rather than tell you what to do with Fibonacci retracement, I’ll explain it and let you decide.

I like to keep things simple. When you join my Trading Challenge you’ll see just how simple. You’ll still have to study your butt off and you might even decide to use Fibonacci retracements as part of your strategy. But I’ll teach you what my other students are doing to become self-sufficient traders.  

Table of Contents

What is Fibonacci Retracement?

Fibonacci retracement levels explained: In a nutshell, these are support and resistance levels based on ratios created with numbers in the Fibonacci sequence.

The idea is, a trend is likely to continue once there has been a retracement to one of the Fibonacci levels

In case you don’t know, the Fibonacci numbers are a sequence described by the 13th-century Italian mathematician Leonardo Pisano Bigollo. Today he’s called Fibonacci because, in the 1800s, some historian called him Leonardo filius Bonacci — or Leonardo, son of Bonacci.

Onward. The sequence named after this really smart guy is pretty cool. Check it out: Start with zero and one, then add each number in the sequence to the previous number to get the next number. 0 + 1 = 1, 1 + 1 = 2, 2 + 1 = 3, 3 + 2 = 5, 5 + 3 = 8, and so on.

Here’s the sequence: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, etc.  

Right. So I can hear you asking, “Tim, what in the heck does this have to do with trading penny stocks, dude?”

I’m laughing right now because I sorta agree! But stay with me here, because this is good stuff to know.   

Here’s how it works: take any two adjacent numbers in the sequence and divide the lower number by the higher number. For example, 5 ÷ 8 = 0.625; 8 ÷ 13 = 0.61538; and 13 ÷ 21 = 0.61904.

Notice they are all very close to 62%? If you keep going like this, the numbers continue to approach 61.8% which is the number accepted as the average of this ratio. Keep 61.8% in mind; we’ll come back to it.

Back to those Fibonacci numbers …

Next, take a number in the sequence and divide it by the number which is two further along in the sequence. This equation gives you a number close to and approaching 38.2%. For example, 55 ÷ 144 = 0.3819. You can do this with any of the numbers in the sequence and you’ll get roughly 38.2%.

If you keep going, by dividing by the number which is three further along in the sequence, you get 23.6%. So far we have 61.8%, 38.2%, and 23.6%. Those are all the Fibonacci ratios used for retracement. However, the indicator uses 0% and 100%. And most of these retracements also include 50%, even though 50% is not one of the ratios.

Why 0%, 50% and 100%?

The 50% ratio has nothing to do with Fibonacci. It’s based on Dow Theory which says a trend has a good chance of continuing once there has been a 50% retracement (either a pullback or an impulse). 0% and 100% represent the high and low price used to create the Fibonacci retracement.  

Before you think you need to be good at math for this, let me say this: I’m not good at math. You don’t have to be good at math. Pretty much every modern stock trading and charting platform has Fibonacci retracement built-in.

The levels are calculated in relation to the vertical distance between high and low — or the 0% and 100% lines.  

The theory is, if a stock has shot up over a period of days and starts to pull back, there will be support at the Fibonacci levels below the high. Likewise, if a stock has fallen and bounces back up, you’d see resistance at the Fibonacci levels.

Why is 1.618 The Golden Ratio?

Fibonacci-retracementGolden ratio concept – 3d rendering created by Sashkin – Shutterstock.com

If you’ve read anything about the ancient Greeks, you’ve probably heard of the golden ratio. This was the name they gave to a ratio based on the inverse of our calculations above. How do you get it? Instead of dividing by the next higher number in a Fibonacci sequence, you divide by the number below.

For example: 8 ÷ 5 = 1.6; 13 ÷ 8 = 1.625; and 144 ÷ 89 = 1.6179. Like our ratios above, as you continue along the sequence, the numbers get closer to 1.618. This is considered the golden ratio.

To be clear, the Greeks — and other cultures —  noticed the golden ratio in nature and started applying it to art and architecture long before Leonardo Bigollo wrote about the sequence.

It’s found in everything from the spirals of shells to patterns in plants, and even constellations and galaxies. In 2010 it was announced in the journal Science that the golden ratio is “present at the atomic scale.”

Hmmm …

Very interesting. But can this help you be a better trader? Keep the golden ratio and how it’s calculated in mind, because later in this post I’ll get back to it.

Benefits of Using Fibonacci Retracement

Pay attention here. What I’m about to tell you might sound slightly controversial. But if you’ve been reading my blog or watching my videos for a while you know I hate the B.S. peddled by some of the so-called gurus out there.

Ok, here it is …

I’m not knocking Fibonacci retracements. Combined with other indicators they might be useful to you. But the greatest benefit of the retracement might be understanding the concept of the self-fulfilling prophecy.

What does that mean? One of the things you want to understand as a trader is human psychology. When it comes to using indicators like Fibonacci retracements, psychology comes into play.

It’s like this: If enough traders use that retracement indicator, then you can potentially predict buy or sell opportunities. And if enough traders act when price action reaches those levels, then it becomes a self-fulfilling prophecy.

Some traders use Fibonacci trading to determine automated stop losses. Be wary, however. There are dozens of possible indicators out there. Not every trader uses Fibonacci levels. But it pays to be aware what other traders might be thinking …

How To Use Fibonacci Retracement in Technical Analysis

Let’s look at Fibonacci retracement on a stock chart. Check out the twitter ($TWTR) chart below. The time frame is the end of November 2018 to market close on December 14.  

twitter ($TWTR) chart with Fibonacci retracement lines. Source FreeStockCharts.com

fibonacci-retracementtwitter ($TWTR) chart with Fibonacci retracement lines. Source FreeStockCharts.com

Recent Highs

Looking at the chart above, you see I chose a recent high as one end of the trend line. Using Fibonacci retracement, once there has been a pullback to one of the retracement levels, the trend is likely to continue in the same direction. The levels act as both support and resistance, depending on who is winning the battle between buyers and sellers.

Notice on December 3, the price consolidated right along the 50% line. Then it dropped back and found brief support at the Fibonacci level of 61.8%. But then the theory falls apart because it dropped below support.

What happened? Lots of Fibonacci lovers consider one further level of support or resistance. They subtract 23.6% from 100% and get 76.4%. If you do the math on this chart, the support level on December 6 is just about where that 76% line would be.

OK, then the upward trend continues and this time the price goes up and finds resistance at our next Fibonacci level, 38.2%, on the 7th. Then it drops back to our 61.8% level which is now a support line. And so on, and so forth.

Recent Pullbacks

On the chart above you see support at Fibonacci levels after pullbacks. But what if the trend is moving down instead of up? It works the same way but in reverse. When you draw the trend line using the Fibonacci retracement tool, go from high to low. The support and resistance lines are reversed.  

A word of warning: I found the above chart pretty fast. But I could also find a chart where the retracement doesn’t work — where price action is all over the place and doesn’t fit the Fibonacci levels in a clean way. Also, this chart is after the fact. You’ve heard the saying: hindsight is 20/20 vision.

How to Use Fibonacci Retracement Tool in Your Day Trading Strategy

So, how should you use Fibonacci retracement in stocks you plan to trade?

Whatever you do, don’t force it!

If you’re ready to trade a stock on your watchlist, make a trading plan. Know your entry and exit points. Know the level of risk and how much you are willing to lose. Check out my Trader Checklist to see how this works.

Whatever you do, before you start making decisions based on Fibonacci retracements, it’s a good idea to see if the chart supports the theory. If you see clear support and/or resistance at the Fibonacci levels, it might be a good idea to use them as part of your plan.

Retracement Warnings

What happens if the stock does not behave? Be prepared. That’s what I always say. Preparation is key. This is not an exact science! So be prepared to cut losses fast or close part of your position to lock in profits.

Don’t get stuck in a trade gone wrong because the friggin’ Fibonacci retracement tool tells you there should be support or resistance at some level. Remember, the indicator gives you an estimated range. If it was exact and reliable every trade would be a winner, right?

Drawing Fibonacci Price Lines

Look at the twitter chart again. Notice the upward trend. Because it is an upward trend, the retracement is low to high. If the trend was down, the retracement would be based on a high to low trend line.

One more thing: I’ve included the candle shadows (the wicks) as the top and bottom of the trend line. Some traders say it’s more accurate if you use the candle body instead of the shadows. I’m sure I could find charts to support both sides of the argument. Again, it’s not an exact science.

Optimizing Fibonacci Retracement Trading

Keep in mind that a lot of technical traders who use Fibonacci do so in conjunction with more than one other indicator. It’s common for technical traders to use Fibonacci retracements, moving average convergence divergence (MACD), and stochastics at the same time.

If you’re going to use these advanced technical indicators, use more than one to confirm your trade thesis as part of your plan. Technical analysis is a complex subject with a lot to learn. Don’t get overwhelmed; keep studying.     

As for me — I like to keep things simple. When you learn how to read a chart, start by identifying basic support and resistance. You can see those levels on most charts without plotting the Fibonacci grid.

How Reliable Is the Fibonacci Retracement in Predicting Stock Behavior?

One of the ways die-hard Fibonacci traders use the ratios is to create Fibonacci projections. To do this, you use the previous price swing and project the Fibonacci levels onto the next swing.

This is where the golden ratio comes into play —  161.8% is one of the projection levels. Other projection levels include 127.2% (the square root of 1.618), 261.8% (divide a number in the Fibonacci sequence by the number two places before it), and 423.6%.

Is Fibonacci projection reliable? If the stock has a  history of reacting to Fibonacci retracement levels, then projecting into the future could be fairly reliable. Be careful, however, as things can get very skewed depending on where you start and end the trend line.

By the way, if you want to dig deep into Fibonacci stuff, there are several books available on the subject. I still recommend you keep things simple. My top student, Tim Grittani, didn’t use any of these indicators his first few years of trading. When he did add one, it was VWAP (volume weighted average price).

Example of How Fibonacci Retracement Can Be Used

If you’re determined to give this indicator a go, start with paper trading.

How should you use it? First, be aware there are traders who believe in Fibonacci retracement levels and use them as entry and exit points.

By understanding this, you can use the levels to confirm or deny your trade thesis. But remember, it’s subjective and there is human psychology at play. The price action may or may not follow Fibonacci levels.

Key Tips to Follow While Using the Fibonacci Retracement Tool

fibonacci-retracement-trading© 2018 Millionaire Media, LLC

Never Chase Your Losses

Cut your losses quickly. It’s my #1 trading rule.

I tend to be a conservative trader. Plus I’ve lost some pretty hefty sums on trades over the years. Learn from my mistakes!

The worst thing you can do to try to chase a trade. So if the trade is going against you but the Fibonacci retracement tells you it shouldn’t — get the hell out!

Always follow this credo. If things go against you, get out. Close your position. Cut your losses.

Then you can take a step back and figure out what went wrong. Learn the lesson from the trade. If you start chasing losses and trying to make up for the loss you’ll lose more. So don’t do it!

Don’t Trust in Stock Promoters

I say this over and over again. The reason I mention it here is because sometimes stock promoters use technical analysis terminology to pump stocks. “Based on Fibonacci retracement, this super stock will break out to new highs and you could turn every $1,000 you invest into $14,276!” Yeah, right. That’s a huge load of B.S.

Like I keep saying, learn to play the pump and dump — but don’t believe the hype. What should you do to play it? First, apply for my Trading Challenge. That’s where you can learn how to be a self-sufficient trader

Never Stop Learning

Even if you don’t make a decision to join the Trading Challenge, you should set the intention to never stop learning. This is a lifelong skill. As such, it takes time and effort to learn. You can’t cheat success.

What’s the Trading Challenge? It’s my top course for creating self-sufficient, knowledgeable traders. My goal: create as many self-sufficient students as possible.

What do you get as part of the Trading Challenge? Glad you asked …

Access to hundreds of instructional videos, live webinars, a community of dedicated traders, and mentoring from some seriously incredible traders. It’s awesome. But you’ll have to work. It’s not a gimme — it takes dedication and serious commitment.  

The Bottom Line

Fibonacci retracements might inform your trading plan. Then again, you might decide to keep it simple like I do and like most of my top students do.

There are traders out there who swear by this indicator. They specialize in trading stocks or forex based primarily on the Fibonacci retracement levels.

Should you use them in your trading? One of the basic ideas I teach as part of the Trading Challenge is that we’re all different. You need to decide if using this indicator works as part of your strategy.

I recommend you keep a watchlist. Then you can paper trade using Fibonacci retracement levels to see if it suits you.

Are you a trader? Do you use Fibonacci retracement as part of your strategy? Comment below — let me know how it’s working for you.