Fibonacci Retracement Basics
I’m going to start off with a very elementary look at the principles of Fibonacci retracement analysis. This, by itself, isn’t really a trading method; it’s just a way to analyze the recent price action so you’re better equipped to make decisions. (I’ll cover the actual entry and exit strategies, and other analysis methods that I use to backup my Fibonacci retracement analysis, in the Trading Strategies pages to come.)
Note: The following MetaTrader screenshots and explanations are here to illustrate the basics of Fibonacci retracements. They’re not intended to show any actual trade recommendations (They’re also long past, so unless you can time travel, it’s too late anyway.)
STEP 1:
Pictured in this EUR/USD chart (above), we can identify points A and B as the last major swing low (A) and swing high (B).
Notice that, at point C, the market failed to make another higher high. This is why I would choose this moment to consider using the most recent swing (that move from A to B) for our retracement analysis. As always, there’s a good chance even I could be wrong about this (the market might just re-test the resistance level at point C and break it — in other words, it might just continue upward without retracing much) but if I am, no harm would be done as long as it didn’t trigger a trade.
Remember, this is for retracement analysis right now (the process of looking for what might happen; NOT a time to start “assuming” anything will happen — keep that difference in mind.) This is NOT a reason to jump into a trade yet, it’s just a reason to begin drawing with the Fibonacci retracement tool in the next step.
NOTE: For those of you who already know a little about Fibonacci retracement: This scenario was chosen to illustrate a point, but for the readers who asked about the choice of highs and lows… I would choose point A and point B (as shown) because those are the most recent “unbroken” peaks on the chart (the market hasn’t gone below or above them during the course of this recent short-term trend.) This is actually a 15-minute chart, so realistically, there wouldn’t be any smaller swings that would be of any real significance. If you were doing this with a 1-Hour chart or above (which does work too), there might be some extra opportunities along the way.
For the beginners, you can ignore this note for now and just try to grasp the basic idea of finding the low and high of a swing in price action.
STEP 2:
Find your Forex trading software’s Fibonacci retracement tool. In MetaTrader (pictured), look for the little “F” icon with the dotted lines (highlighted in the picture, above). Click it.
Note: I’m using MetaTrader as the main demonstration tool because it’s still the most popular platform for online forex trading. Obviously, there are quite a few alternatives out there, but most of them are either unique to a single broker (developed in-house) or designed for institutional accounts that most beginners just won’t realistically have access to (yet.) Still, if you’re using any popular Forex broker that uses their own proprietary trading platform (like OANDA’s FXTrade or FXCM’s Trading Station II) then it shouldn’t be too hard to find your software’s version of the Fibonacci tool. They all have it, it’s just a matter of how and where to access it. (Check the platform’s help pages if you really can’t find it.)
STEP 3:
Using the MetaTrader platform (as pictured), you click and hold on the bottom of point A and drag your mouse to the top of point B. If this were a down swing (ie. A would be the top and B would be the bottom), then you would drag from top to bottom — either way, you would still start from left to right.
In some trading platforms, such as OANDA FX Trade, you don’t drag the mouse. Instead, you would just click on A (click once) and then click again on B, and the result should look essentially the same. Once you get past these minor differences between the different platforms, you’ll find that the Fibonacci tool will ultimately show you the same information.
And yes, you’ll find it in most of the decent stock trading platforms too. (Probably not the lackluster web-based ones but if you have a decent “active traders” broker like Interactive Brokers, you can find most of the same tools.)
STEP 4:
And there you have it. EUR/USD (Euro vs US Dollar) retraced past four of the major Fibonacci retracement levels (D, E, F, G) before stalling and possibly re-testing the swing high (B).
PRACTICAL NOTES:
If you’re wondering how this could actually be used in the real market, imagine that you decided in Step 3 to trade a “counter-trend” move toward the 50% (F) or 61.8% (G) retracement zones. You would use the swing high (B) as your stop loss. As you can plainly see, either of the two targets would have given you a decent risk-reward ratio since they would both be larger than your stop loss. In a worst case scenario, you would get stopped out and have a choice to reverse your position to follow the trend of the original up-swing (A to B).
Again, this strategy for entry and exit isn’t the point of this article. I just wanted to illustrate a basic way of looking at retracement analysis and Fibonacci trading in general. In the articles to come, I’ll get into more of the juicy stuff as far as actually using these scenarios to your advantage.
Remember, it’s all about stacking the odds in your favor, whether you’re Fibonacci trading or just scalping round numbers. Fibonacci retracement analysis is just one of the tools in your arsenal.
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