How to Use Fibonacci Retracement Levels in Day Trading
A tool that helps isolate when pullbacks could end
During a trend there are moves in the trending direction, called impulses, and moves against the trend called pullbacks. Fibonacci retracement levels highlight a few areas where the pullback could reverse and head back in the trending direction. Therefore, Fibonacci retracement levels can be helpful in confirming trend trading entry points. Here's what these levels are, and how to use them.
Fibonacci Level History
Fibonacci levels are derived from a number series that Leonardo Pisano Bogollo introduce to the West in the 13th century.
The sequence starts like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89...
Each new number is the sum of the two numbers before it. By performing various calculations a number of percentages are derived from the sequence. These percentages are called Fibonacci retracement levels in trading.
For example, a number divided by the next highest number produces 0.618 (not at the start of the sequence, but as the numbers progress). A number divided by the number two spots ahead produces 0.3820. A number divided by three places ahead produces 0.2360. Subtract 0.2360 from 1.0 and the result is 0.764. Note that 0.786 is also used, but in day trading these two levels will be so close together that it doesn't matter which you use.
Converted to percentages those are the Fibonacci retracement levels: 76.4%, 61.8%, 38.2% and 23.6%. 50% is also used; it's not an official Fibonacci retracement level but rather is based on Dow Theory.
How to Use Fibonacci Retracement Levels
Select the Fibonacci retracement tool on your chart or trading platform.
The tool also has 0 and 100 levels, in addition to the levels mentioned above. 0 and 100 mark the end and starting point of a price wave.
If the trend is up (see How to Effectively Use Trendlines), extend the tool from the starting point to the high of a price wave.
0 should be at the high point. If the price pulls back 23.6% of that wave it will be at your 23.6% retracement level. If it pulls back 61.8% it will be at the 61.8% Fibonacci level.
If the trend is down, extend the tool from the starting point to the low of a price wave. 0 should be at the low point. If the price pulls back 23.6% from the low (or that wave) it will be at your 23.6% retracement level. If it pulls back 61.8% it will be at the 61.8% Fibonacci level.
The tool only measures the specific area where you have drawn the tool. For example, if a stock rallies from $123.50 to $124, and you draw a Fibonacci retracement tool on that move, the 50% retracement level will be $123.75.
The 61.8% and 76.4% level mean the price has retraced much of the prior move. Levels such as 23.6% and 38.2% mean the price has only retraced a small portion of the prior move.
How to Use Fibonacci Retracement Levels
As the price is moving draw Fibonacci retracement levels. When a trend is moving very strongly pullbacks will typically only reach the 23.6%, 38.2% or 50% levels. Early or late in trends, when the price is still gaining steam or losing steam, it is more typical to see retracements to the 50%, 61.8% and 76.4% levels.
For example, during a strong downtrend, like the 1-minute crude oil futures chart attached, the pullback only retraces 23.6% (give or take a margin of error) of the prior down move before continuing to decline. Here's a bigger version of the chart.
If your day trading strategy provides a short sell signal in that price region, the Fibonacci level helps confirm the signal. The Fibonacci levels also point out price areas where you should be on high alert for trading opportunities.
Using a Fibonacci retracement tool is subjective. There are multiple price swings in a trading day, so not everyone will be connecting the same two points. The two points I connect may not be the two points you connect. To help compensate for this, draw retracement levels on all significant price waves, noting where there is a cluster of "Fib" levels--this may indicate a price area of high importance.
Fibonacci Retracement Warnings and Final Word
While useful, Fibonacci levels will not always pinpoint exact market turning points. They provide an estimated entry area but not an exact entry point. There is no guarantee the price will stop and reverse at a particular Fibonacci level, or at any of them. If the price retraces 100% of the last price wave the trend may be in question.
If you use the Fibonacci retracement tool on very small price moves it may not provide much insight. The levels will be so close together that almost every price level appears important.
Fibonacci retracements provide some areas of interest to watch on pullbacks. They can act as a confirmation if you get a trade signal in the area of a Fibonacci level. Traders don't need to use them though. Play around with Fibonacci retracements levels and apply them to your charts. Incorporate them into your trading plan only if you find they help your trading.