Many technical patterns have some degree of merit. The ones I’ve been sharing in this ongoing technical education series are easily the best of the best.
But there’s one pattern that stands head and shoulders above the rest.
It’s one of the oldest patterns still widely in use by traders today. It’s also one of the most popular trading indicators — so popular that nearly every pattern trader uses it at some point in their career.
Of course, that’s not at all surprising when you know everything this indicator can do.
It can tell you when a rally/pullback is forming in the markets.
It can tell you the percentage amount the markets will move.
It can even tell you how long that rally/pullback will last.
And it does this for everything you trade — gold, oil, stocks, bonds, even currencies — for the most part, they all follow the same pattern.
Just about anything you can trade tends to snap back to this price pattern before resuming the overall trend either up or down, which is exactly why technical analysts love it — it’s easy to spot (and trade) trend reversals right down to the decimal.
In fact, experts say this indicator can predict about 70% of all market moves.
That’s a huge edge for traders… as long as they’re actually using the indicator properly. If they’re not, it can lead to a host of disastrous results.
Fibonacci Retracement Levels: A “Golden” Ratio for Winning Trades
The indicator we’re talking about today is Fibonacci retracement levels — a series of technical lines based on the famed Fibonacci sequence and ratio. (You know the one; that “golden ratio” that seems to appear all over nature and art, from sunflowers and nautilus shells to even the Parthenon.)
Quick history lesson: Fibonacci retracement levels owe their name to Leonardo Pisano Bigollo, known famously as Leonardo Fibonacci. But it’s essential to note that he didn’t create the Fibonacci sequence; he merely introduced it to Western Europe. The sequence itself was formulated in ancient India between 450 and 200 BCE.
The Fibonacci Sequence is a series of numbers where each number is the sum of the two preceding ones: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, and so on.
Even more impressive is that each number is about 1.618 times greater than the preceding number. And the relationship between all these numbers in the sequence is the foundation of common ratios when studying retracements (the percentage by which the market corrects itself).
Now this 1.618 number is known as the “golden ratio” or “golden mean,” and is determined by dividing a number in the sequence by the number that follows it. For example, 55/89= 0.617, 34/55= 0.618, 21/34= 0.617, and so forth, making 61.8% the key Fibonacci ratio.
There are also three other key ratios technicians use:
23.6%, which you can find by dividing one number in the sequence by the number three places to its right.
38.2%, which you can find by dividing one number in the sequence by the number two places to its right.
50.0%, which is not an actual Fibonacci ratio but is also widely used due to its significance in market psychology.
Anything you trade (whether it’s stocks, bonds, commodities, futures, or currencies) tends to pull back to these percentage retracement levels before resuming the overall trend either up or down, which is exactly why technical analysts love the Fibonacci sequence. It’s easy to spot – and trade – trend reversals right down to the decimal.
Traders apply Fibonacci ratios to determine price levels, or where price may retrace or project to – identifying potential levels of support and resistance. Fibonacci trading has much to do with price activity breaking up or down and then following through to a particular price target.
For example, let’s say a stock you like has been on a big rally, but you want to enter at a lower price. You can use your Fibonacci retracement lines to see where the most likely support lines are and then use those lines to create your entry target. You can see a great example of this on the chart below.
First, to plot your Fibonacci retracement levels after a rally, you would select the Fibonacci retracement lines in your charting software, then click on the LOW (A) and drag to the HIGH point of the chart (B). (Note that I’m using the candle WICKS to plot my low and high levels; you can use candle bodies or closing prices, but the key is to be consistent. More on this later.)
The low should correspond with a 100% retracement level, because a pullback of this magnitude would mean the shares have forfeited 100% of their gains from the rally.
The high should correspond to a 0% retracement level.
The Fibonacci levels that populate between the low and high often emerge as levels of chart support on pullback. These levels act as magnets, drawing prices towards them. However, once a level is breached, the next Fibonacci level often becomes the target.
As you can see in the chart above, the stock price topped out at the high anchor point, then retraced 50% before moving back up 50% of its move down. The price then retraced back down to the 38.2% level before moving up, continuing the prior uptrend.
Note – the distance from B to C is 50% of A to B. The distance from points C to D is 50% of B to C. And to be consistent, the distance from D to E is 50% of C to D. Very interesting, isn’t it?
We can do this with bearish setups as well. If a stock has taken a nosedive on the charts, you could plot Fibonacci retracement levels going the other way. For this, you’d start by clicking on the HIGH anchor point (A) and dragging to the LOW (B). In this instance, Fibonacci retracement levels could tell you where potential resistance levels are on a stock that has tanked and bounced.
This time, the high should correspond with a 100% retracement level, because a rally to this level would mean the shares have completed a 100% retracement of its original move.
The low should correspond to a 0% retracement level.
In this case, the stock was moving lower from A until it found support at B. About two weeks later, it posted a “double bottom” at C then proceeded to retrace to the 38.2% level at point D. That level held as resistance a number of times, predicting the stock price should move lower, setting up a bearish trading opportunity.
It’s clear why technical analysts love Fibonacci retracements; knowing where these key levels are most likely to appear is a great way to optimize your trade setups.
Avoiding the Mix-Up: Fibonacci Trading’s Common Slip-Up
Alright, let’s talk about a classic mistake many new traders make when using Fibonacci levels — mixing up their reference points.
By “reference points,” I’m referring to where you’re drawing your “high” and “low” lines. Think of these reference points as the anchor of your levels. Most traders typically use candle wicks (the thin line at the top and bottom of the candle), while others use the candle bodies (the wide rectangle portion of the candle). Both are fine, as long as you stay consistent. Inconsistent reference points mean inconsistent Fibonacci levels, which can end up causing a lot of confusion and messy trades.
So, here’s the trick to using this tool correctly: If you’re using the tip of a candle’s wick to measure the high, do the same for the low. If you’re looking at the body of the candle for the high, stick with the body for the low too. Mixing things up, like jumping from a wick to a candle’s body, can throw off your whole game. Remember, consistency is key to keeping your trades on point.
Finally, keep in mind that Fib Levels work best alongside other non-correlated indicators that can enhance/confirm what you’re seeing. For example, you should be aware of how retracement lines stack up with other support/resistance areas. If multiple lines are indicating strong support around the same level, there’s an even better chance that level will act as strong support. That said, don’t let yourself get stuck in “analysis paralysis” by using too many indicators. Usually around three unrelated studies should be adequate to build a successful system.
If you’re interested in this style of pattern trading, I highly recommend you check out this interview I just recorded with my star student, a former golf pro turned millionaire trader.
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To your continued success,
America’s #1 Pattern Trader