How to trade with Fibonacci levels

Before reading through this lesson, you should have previously read through:

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The term “Fibonacci” when used in trading refers to a tool that measures the size of a price move and subsequently places horizontal support and resistance levels on a price chart. These support and resistance levels are referred to as "Fibonacci levels" and are used to make trading decisions in the same way as normal horizontal support and resistance levels.

If you would like to find out how to practically set up and use the Fibonacci tool, then you can visit our tutorial:

Article
How to set up Fibonacci retracement levels in MetaTrader 4.
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The Fibonacci tool is applied to a price move

Fibonacci levels are retracement and extension levels that work as support and resistance on your price chart.

When the price moves in any direction, the beginning and the end of that move can be clearly identified. Using the Fibonacci tool, you measure the distance of that move and the Fibonacci tool will automatically place what is called Fibonacci retracement and extension levels – these are explained in more detail later.

The actual calculations of the Fibonacci levels are based on the numbers in the Fibonacci sequence, or rather the percentage difference between them. However, for this lesson we will simply show you how to use this tool rather than explaining the mathematics behind it.

Start from the beginning of the price move to the end

The Fibonacci tool is applied manually. When measuring a downtrend, you apply the tool at the start of the move to the end – it is always applied from left to right. The chart below demonstrates this:

Fibonacci drawing in a downtrend

number_1 The tool drawn starting at the top
number_2 The tool ends at the bottom, drawn from left to right

For an upward move, the tool is applied from the bottom and ending at the top – again it is always applied from left to right. The following demonstrates this on a chart:

Fibonacci drawing in an uptrend

number_1 The tool drawn starting at the bottom
number_2 The tool ends at the top, drawn from left to right

Fibonacci levels are automatically placed in MT4

As you can see in the charts above, after the Fibonacci tool has been applied, it automatically places the Fibonacci levels between the start and the end of the move. These levels are referred to as retracement levels.

Fibonacci levels are shown as percentages of that total move. So the level that has been placed half way between the start and the end of the move is the 50% retracement level. So if the price then retraced halfway back, it is said to have retraced to the 50% level. This then acts as support or resistance, depending on which way the trend is.

The 38.2%, 50% and 61.8% levels are the most commonly used levels that the price could retrace back to.

The retracement levels therefore tell us how far the pull back could be.

In the chart below you can see the 38.2%, 50% and 61.8% levels. These are commonly used levels that the price could retrace back to, although there are other retracement levels that have been identified and work well.

Fibonacci retracement levels

number_1 38.2% level
number_2 50.0% level
number_3 61.8% level

Fibonacci retracement levels can be used for entries

As you can see from the chart below, the Fibonacci tool was applied to an uptrend and the 38.2%, 50% and 61.8% levels was placed in between the start and the end of the move. As these are levels that the price could retrace back to, you can then use them for potential entries.

Fibonacci long entry

el1 Potential long entry at 61.8%
el2 Potential long entry at 50.0%
el3 Potential long entry at 38.2%

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How to choose the correct level to enter

There are two ways to choose which retracement levels you use to enter into the markets:

1. Aggressively enter as the price reaches each level.

You could enter at each retracement level placing a stop loss on the other side of the Fibonacci level. If your stop loss is hit, you simply enter again at the next level and carry on until the price goes back in your favour. This is an aggressive way of finding entries using the Fibonacci tool.

You can aggressively enter at each level while placing your stop loss on the other side, or you can more passively wait for price to find support or resistance at these levels.

2. Wait until the price finds support or resistance at these levels first, and then enter.

You wait until the price finds support or resistance at these levels, wait for the price to move back in the original direction of the trend and then enter.

It is important to note that Fibonacci is not a trading system in itself – it has to be used in conjunction with or as part of a trading system.

Fibonacci extension levels

The Fibonacci tool is not only used to establish the retracement levels for traders as support or resistance; it can also project extension levels that show where the price could go to. Fibonacci extensions can therefore be used for profit taking or even counter trend entries.

The most common extension levels used by traders are the 138.2% and 161.8% levels, although there are many other extension levels used by different traders. The following is an example of extension levels in a downtrend.

Fibonacci extension levels downtrend

number_1 138.2% extension level
number_2 161.8% extension level

The Fibonacci tool can be used to enter a position at one of the retracement levels when the price pulls back and then exit at one of the extension levels.

Below is a chart showing the extension levels of the Fibonacci tool applied to an uptrend. You can see the retracement and extensions levels.

Fibonacci extension levels

number_1 Potential long entry at a retracement level
number_2 Potential exit at an extension level

How to choose the extension level at which to take profit

The extension levels can be matched to the corresponding retracement levels to maximise profitability. For example, if the price retraced to the 38.2% retracement level, then the related extension level would be the 138.2.

Fibonacci extension retracement 38

number_1 Short entry at 38.2% retracement level
number_2 Corresponding extension level at 138.2%

The related extension to the 50.0 or 61.8 retracement level is the 161.8.

Fibonacci retracement extension

number_1 Short entry at 50.0% retracement level
number_2 Corresponding extension level at 161.8%

The first question you may ask is “why do Fibonacci retracement and extension levels correspond with each other?”. The answer comes back to a self-fulfilling prophecy. Banks and large financial institutions will look to take their profit at some point and targeting a Fibonacci extension level is one method they use. They will be expecting other banks and traders to exit at these levels and so based on these expectations, they do the same – hence a self-fulfilling prophecy.

Though extension levels work as self-fulfilling prophecies for profit targets, it is not a fixed rule and there must be a confirmed trend.

However, it is important to note that this is not a fixed rule; for extension levels to work, they must be in a confirmed trend and this does not happen every time.

Using each level as a target

An easier method of using the extension levels is simply to exit when the price seems to find significant support or resistance there. In other words, if the price seems to have trouble breaking through a Fibonacci level, then this can be deemed a good exit.

Summary

So far, you have learned that ...

  • ... the Fibonacci tool places support and resistance lines on a chart, based on a price movement.
  • ... the Fibonacci tool is always applied from the left hand side over to the right hand side of the price chart, for both long trades in an uptrend and short trades in a downtrend.
  • ... the levels placed between the start and the end of the initial move are retracement levels and they show where the price could retrace back to.
  • ... the most common Fibonacci retracement levels are the 38.2 %, 50% and 61.8% and are commonly used for entries into the market.
  • ... there are two ways to use retracement levels for entries, aggressively – entering at each level and passively – waiting for the price to go back in the original direction first.
  • ... the levels placed beyond the initial price move are extension levels and they show where the price could go to.
  • ... the most common extension levels are the 138.2% and 161.8% levels and are commonly used for exits out of the market.
  • ... retracement levels and extension levels can correspond, with a retracement to the 38.2% commonly carrying on to the 138.2% and a retracement to the 50% and 61.8% commonly carrying on to the 161.8% level.

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  • what is this approach of fib drawing? Something missing here or my drawings in last 6 years was wrong smile Order of levels are not what appear in mt4 fib drawing tool .

    138.2 and 161.8 are above level 100.00 (dowtrend example) not below 0. 00 as You published.

    also some other levels are even more important to trade harmonichs patterns but ok..that could be some other lesson.
  • There are many equally good ways to draw fibonacci levels. In this approach we are able to display retracement and expansion 2 in 1.
  • hindsighthero:
    There are many equally good ways to draw fibonacci levels. In this approach we are able to display retracement and expansion 2 in 1.

    I sow that this is some hybrid approach but YOu do not mentioned that in lesson.

    Basicaly this is ab cd harmonic patern introduced itrough a package of retreacment form one fib level and go to other
  • can You please explain what level You puting into mt4 fib tool as value , to get this hybrid levels 138.2, 161.8 placed in this order.
  • strob25:
    can You please explain what level You puting into mt4 fib tool as value , to get this hybrid levels 138.2, 161.8 placed in this order.

    Hey strob25,

    We have an article on how to draw fibonacci levels here.

    But to answer your question you can draw the 161.8 and 138.2 by entering a fibo value of
    -0.618 and -0.328.
  • You can use -0.382 level for 138.2%, -0.618 for 161.8% extension... in the fib properties

    regards
    Hindsighthero
  • thank you very much.. both off You. I try that way but this levels are not same like when I put classic expansion fib draw tool. But still are intersting to meassure ab-cd harmonics pattern.
  • I'm still a little bit confused as where to use the fibonacci. Can I use it on a trend that have already start (and probably close to end) or should I wait for another trend to start. For example, in this situation would it be better to wait for a new trend or could I use the fibonacci to trade? If it can still be used, where should the fibonacci start A, B, C, D? Thank you.

    http://imageshack.us/photo/my-images/689/bskn.png/

    Edit: By the way, how can I make the image appear on the post?
  • is it wrong to use fractal to identify swings? and why 38.2% retracement is to 138.2% extension only? I thought that the smaller the retracement is a bigger the move?

    Please clarify this.

    Best Regards

    DREi.
  • Hi Faststare,
    My thinking is that a small retracement only attracts short term traders while a bigger attracts both short and longer term traders so it makes sense to me to expect a larger move after larger retracement. Regards.
    Peter
  • thanks sir peter. but can I use higher timeframe fractal to draw the fibs then switch back to my entry timeframe or is it still wrong? I'm kinda lame to use fibs when it's live.
  • You can use fibs on any timeframe as long as there are two visible swing points. They supposed to highlight important areas between those two points where price might stop, consolidate or reverse.
  • ok sir. it's adds with my trading arsenals. i'm nearer to be a successful trader. :3
  • Hi,
    "retracement levels and extension levels can correspond, with a retracement to the 38.2% commonly carrying on to the 138.2% and a retracement to the 50% and 61.8% commonly carrying on to the 161.8% level."
    [IMG]http://imageshack.us/a/img15/9350/1amz.th.png[/IMG]


    In the picture above, it is a retracement to 38.2 or 50.0?
    Thanks.
  • Hi JHTAN,
    I would say it is 50 %. smile
  • hindsighthero:
    Hi JHTAN,
    I would say it is 50 %. smile
    However, there is a bullish candlestick at 38.2.
  • When measuring retracement i think you want to include the entire move and that reached 50%.
  • Hello,
    "You could enter at each retracement level placing a stop loss on the other side of the Fibonacci level."
    May you explain the above statement?
    My understanding on this statement is let say Entry is 50%, SL is 61% and Entry is 38.2%, SL is 50%. Both are going long.
    Thanks.
  • Hi JHTAN,
    You can do it your way as well of course. The above statement is only to show how to aggressively react to price reaching a certain fib level. Aggressive usually means: tight stop, and less confirmation that is you want the price to turn on the spot and leaving the price prove you wrong at the next fib is not really catching the reversal in such an aggressive manner. Regards.
    Peter

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