How to Use Fibonacci Retracement Levels in Day Trading

Tool helps isolate when pullbacks could end

Fibonacci retracement levels
••• Crude 1-Minute Chart Falls Off 23.6% Fibonacci Retracement Level. Thinkorswim

Moves in a trending direction are called impulses, and moves against a trend are called pullbacks. Fibonacci retracement levels highlight a few areas where the pullback could reverse and head back in the trending direction, making them helpful in confirming trend-trading entry points. Here's what these levels are, and how to use them. 

History

Fibonacci levels are derived from a number series that Italian mathematician Leonardo Pisano Bogollo—also known as Fibonacci—introduced 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. As the sequence progresses, each number is approximately 61.8 percent of the next number, approximately 38.2 percent of the following number, and approximately 23.6 percent of the next number after that. Subtract 23.6 from 100 and the result is 76.4.

These are Fibonacci retracement levels: 76.4, 61.8, 38.2, and 23.6.

Why Is This Special?

What Fibonacci and scholars before him discovered is that this sequence is prevalent in nature in spiral shapes such as seashells, flowers, and even constellations. As a spiral grows outward, it does so at roughly the same rate as the percentages derived from the Fibonacci ratios.

Some believe these ratios extend beyond just shapes in nature and actually predict human behavior. The thinking is that people start to become uncomfortable with trends that cause changes to happen too rapidly and adjust their behavior to slow or reverse the trend.

For example, if someone starts out with $100 in his wallet, he will begin to slow his spending—or stop altogether—once he has spent about $61.80 and has only about $38.20 remaining.

How to Use Them

When a stock is trending very strongly in one direction, the belief is that the pullback will amount to one of the percentages included within the Fibonacci retracement levels: 23.6, 38.2, 61.8, or 76.4.

Some models also will include 50 percent. For example, if a stock jumps from $10 to $11, the pullback should be expected to be approximately 23 cents, 38 cents, 50 cents, 62 cents, or 76 cents. Early or late in trends, when a price is still gaining steam or losing steam, it is more typical to see retracements at the higher percentages.

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 during a trading day, so not everyone will be connecting the same two points. The two points you connect may not be the two points others connect. To help compensate for this, draw retracement levels on all significant price waves, noting where there is a cluster of Fibonacci 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 percent 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. Play around with Fibonacci retracement levels and apply them to your charts. Incorporate them into your trading plan only if you find they help your trading.