Unlocking the power of Fibonacci retracements in trading

Stanislav Bernukhov

Senior Trading Specialist at Mt8Pro

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This is not investment advice. Past performance is not an indication of future results. Your capital is at risk, please trade responsibly.

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In this guide:

  1. Understanding Fibonacci retracements
  2. 5 steps to applying Fibonacci retracements to stock indices
  3. Applying Fibonacci, scenario 1: Uptrend in the S&P 500
  4. Applying Fibonacci, scenario 2: downtrend in the HK50 index
  5. Pros and cons of Fibonacci trading
  6. Leverage Fibonacci retracements for your indices trading strategy

If you’ve been wanting to boost your indices trading with a new tool, then the Fibonacci retracement indicator might be what you’re looking for.

Trading stock indices is dynamic and often volatile. As a trader, you might be continually looking for ways to add an edge to your trading and make better trading decisions. One valuable tool you can add to your arsenal is the Fibonacci retracement. Named after the famous Italian mathematician Leonardo of Pisa, or Fibonacci, this tool has found its way into the world of trading due to its intriguing ability to identify potential support and resistance levels.

In this article, we will dive deep into the concept of Fibonacci retracements and explore how you can use them effectively to trade stock indices.

Understanding Fibonacci retracements

Fibonacci retracements are technical analysis tools you can use to identify potential reversal levels in a price trend. Fibo retracements reside in the Fibonacci sequence, a series of Fibonacci numbers where each number is the sum of the two before it (0, 1, 1, 2, 3, 5, 8, 13, 21, and so on). In trading, the Fibonacci ratios you can use are:

- 0.236 (23.6%)

- 0.382 (38.2%)

- 0.500 (50%)

- 0.618 (61.8%)

- 0.786 (78.6%)

- 1.000 (100%)

To apply this tool, you need to identify a significant price action (either up or down) and then draw horizontal lines at these key Fibonacci ratios. These Fibonacci retracement lines act as potential levels of support or resistance where price reversals may occur.

An example of building a Fibonacci retracement net.

An example of building a Fibonacci retracement net. Source: Tradingview.com

5 steps to applying Fibonacci retracements to stock indices

Now, let's discuss how to practically use the Fibonacci retracement tool when trading indices with the below 5 steps.

Step 1. Identify a significant price move

The first step in using the Fibonacci retracement tool is to identify a significant price move on the stock index chart. This move could be a recent uptrend or downtrend, depending on your trading strategy. The clearer and more noticeable the trend, the better.

A bullish trend for the NASDAQ index

In this chart we can clearly identify an uptrend for the NASDAQ index (USTEC). Source: Tradingview.com

Step 2. Draw Fibonacci retracement levels

Once you've identified a major price shift, use your charting software to draw the Fibonacci retracement levels. Draw a horizontal line from the lowest point of the move (swing low) to the highest point of the move (swing high) for an uptrend or vice versa for a downtrend. This creates the Fibonacci retracement grid on your chart.

Fibonacci retracement grid for the NASDAQ index

Example: Fibonacci retracement grid for the NASDAQ index. Source: Tradingview.com

Step 3. Interpret the Fibonacci retracement levels

The Fibonacci retracement levels (23.6%, 38.2%, 50%, 61.8%, 78.6%, and 100%) represent potential levels of support and resistance. Here's how to interpret them:

- 23.6% and 38.2%: these are shallow retracements. In an uptrend, you might find potential buying opportunities near these Fibonacci levels. In a downtrend, keep an eye out for possible selling opportunities.

- 50%: this Fibonacci retracement level is often considered one of the most important retracement levels. Watch out for price reactions, as they may signal potential reversals or continuations of market trends.

- 61.8% and 78.6%: these are deeper Fibonacci retracement levels. Look for strong bullish or bearish signals around these points, as they might suggest potential reversals.

- 100%: a retracement to the 100% level means a complete reversal of the previous move. This level is not always reached, but when it is, it can signify a significant trend reversal.

Step 4. Combine with other technical analysis tools

Fibonacci retracements are most effective when paired with other technical analysis tools and indicators. For example, you may use them alongside moving averages, trend lines, and oscillators to help you find potential entry and exit points.

Below is an example of the combination of the 50-day moving average and the 0.382 Fibonacci retracement for the DE30 index (German stock index). The convergence (or merging) of these tools confirms the opportunity to sell.

An example of combining the Fibonacci retracement with a moving average

This example shows a 50-day moving average in combination with a 0.382 Fibonacci retracement for the DE30 index. Source: Tradingview.com

Step 5. Combine with candlestick patterns

You can use candlestick patterns as confirmation of a Fibonacci level, as they show a short-term sentiment shift and may provide a better trade location.

Here’s an example from the AUS200 index in October 2020. After a bullish rally, the index price corrected towards the 0.618 Fibonacci retracement level. Following this correction, an engulfing pattern appeared. This could have been used as a reversal confirmation, meaning that the price could change direction.

Fibonacci retracement with engulfing candlestick pattern

Here is an image of the combination of the 0.618 Fibonacci retracement level and engulfing candlestick pattern mentioned above. Source: Tradingview.com

Applying Fibonacci, scenario 1: Uptrend in the S&P 500

Suppose you're analyzing the S&P 500, and you notice a clear uptrend from 4,338 to 4,470 points. You apply Fibonacci retracement levels from the swing low (4438) to the swing high (4470). As the index begins a sharp retracement, it finds consolidation slightly above the 0.786 level. You might consider placing a buy limit order at this level, since the chances of retesting this level are high. Retest basically is a pullback to the level, which, in most cases, allows a trader to re-enter a position with a better price.

The price sharply retests this level and then rebounds.

An example of the Fibonacci retracement of the S&P 500

In the above example, we see the Fibonacci retracement of the S&P 500 index and a retesting of the 0.786 level. Source: Tradingview.com

Applying Fibonacci, scenario 2: downtrend in the HK50 index

In this scenario, you're analyzing the Hang Seng index (HK50), and you identify a downtrend from the 20343 to 19302 level.

You draw Fibonacci retracement levels from the swing high (20343) to the swing low (19302), and you see that the index hits resistance near the 50% retracement level (around 19800). This could be a potential entry point for a short trade. To reduce risk, you could set a stop loss order just above the 61.8% retracement level (around 19960).

Using the Fibonacci retracement to enter a short trade for HK50

Here we have an example of entering a short trade for the HK50 index using the 50% Fibonacci retracement. Source: Tradingview.com

Pros and cons of Fibonacci trading

Let’s examine some of the advantages and disadvantages of using the Fibonacci indicator when trading: from being able to predict future support or resistance areas, and identifying retracements and extensions to the potential pitfalls of inaccurate predictions, confusion in building levels, and inducing false confidence.

Advantages of Fibonacci

  • Fibonacci-based indicators serve as leading indicators, meaning they can assist you in predicting future support or resistance areas. In contrast, classical levels of support and resistance typically depend on historical price action. If you predict the level correctly, the price tends to react sharply and aggressively, providing a potentially high profit/loss ratio.
  • You can use Fibonacci tools to identify retracements as well as extensions. This application could offer you a potential price target for a winning position.
  • Various Fibonacci levels can reinforce each other. For instance, if several retracement levels congregate around a specific price, this tends to be more reliable.

Disadvantages of Fibonacci

  • Predictive tools like Fibonacci may not always provide precise price levels. They are better at indicating potential reversal areas. You'll need extra tools, like candlestick patterns, to verify these.
  • Setting up Fibo levels correctly can sometimes be complicated. There can be multiple lows and highs, and if you're not careful, you could select the wrong ones when you're constructing your Fibo net. Using Fibonacci tools properly takes some practice.
  • Be cautious with Fibonacci levels as they might give you a false sense of confidence or security. As there aren’t any foolproof methods that will always successfully forecast tops and bottoms when trading the financial markets, this technical analysis tool should be used judiciously.

Frequently asked questions

It’s difficult to say which is a good Fibonacci retracement. In a bullish market, retracements tend to stay between 23.6% and 50%, as pullbacks are usually smaller. In a bearish market, pullbacks might be larger due to increased volatility and may exceed 70%. However, the 50% retracement is probably the most popular one. Some indicators, such as the Ichimoku indicator, are built exclusively around a 50% Fibonacci retracement event.

You can use Fibo retracements on any timeframe because financial markets often repeat themselves. However, using it over shorter periods makes it harder to correctly identify the Fibonacci retracement net due to additional ‘noise’. So, it's suggested that you use these tools on timeframes longer than a 5-minute chart.

The concept of retracement only works if the trend is still in motion. As a trader, your main assumption is that the trend will keep going. However, if the trend has already passed, trying to catch a pullback can be risky. Additionally, if a price move is triggered by news, it can cause a major shift in market sentiment and potentially a reversal. In such situations, using Fibo retracements can also be risky for you.

There are several Fibonacci extensions, but the most popular are 1.236% and 1.618%. Sometimes, when the market is moving fast, it can reach a 2.618% level. However, it’s recommended that you gauge the market volatility realistically. If the projected target is located within the daily or weekly average volatility range, the probability of achieving this target increases substantially. You can use tools like the average true range indicator (ATR) to calculate volatility.

A Fibonacci net is a series of levels, built automatically when a trader connects two dots (high and low) on the chart. The Fibonacci net points to a potential price level for retracements and extensions. Fibonacci tools also include Fibo arcs, Fibo time zones, Fibo channels and Fibo circles.

Here is an example of the ‘Fibonacci wedge’ tool, as applied to XAUUSD. Source: Tradingview.com

Leverage Fibonacci retracements for your indices trading strategy

The Fibonacci can be a helpful tool for you when trading indices. They can help you identify potential support and resistance levels, and decide when to enter or exit a trade. However, it's essential you remember that no technical analysis tool is foolproof and that risk management is paramount in trading stock indices.

To use Fibonacci retracements effectively, you must combine them with other tools for technical analysis and continuously improve your technical analysis skills through practice and testing.

By doing so, you can unlock the power of Fibonacci and boost your chances of success in the indices market.

Ready to level-up your trading? Start trading indices with Mt8Pro today. Find the right account for your needs.

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This is not investment advice. Past performance is not an indication of future results. Your capital is at risk, please trade responsibly.