Based on the Fibonacci sequence, Fibonacci ratios can pinpoint potential support and resistance levels in financial markets. It helps traders anticipate where prices might pause, reverse, or continue their trend. The Fibonacci retracement tool is commonly used to measure pullbacks in a trend.
The Fibonacci tool is not inherently related to Bollinger Bands; instead, traders use Fibonacci levels in conjunction with Bollinger Bands and other tools to confirm trading opportunities, as these tools measure different aspects of market price movements.
We've previously published a series of articles on Bollinger Bands® (BB), a powerful technical analysis tool. If you're new to Bollinger Bands, please refer to our introductory article, "Bollinger Bands - Introduction and Key Points," and our article on the four main patterns: "Squeeze, expansion, max bandwidth and bandwalk."
Based on the Fibonacci sequence, Fibonacci ratios can pinpoint potential support and resistance levels in financial markets. This helps traders anticipate where prices might pause, reverse, or continue their trend.
The Fibonacci retracement tool is commonly used to measure pullbacks in a trend. Fibonacci retracement levels help identify potential support and resistance areas by measuring how much a security's price retracts before continuing its trend. Although not based on fundamental analysis, these levels are widely used because they often align with market psychology and have been observed in various natural phenomena.
This article will demonstrate how to utilise the Fibonacci retracement tool to determine the direction of the market trend.
1. Helping to identify trend direction
Fibonacci Retracement is a tool that helps us predict the extent of downward and upward movements. In contrast, Fibonacci extension lines predict what will happen to the price following a correction or retracement.
This idea might be easier to understand by looking at the N-wave principle, which refers to the concept of viewing three waves of "rise → decline → rise" or "fall → retracement → fall" as a set.
Next, let's explain the A-B-C-D N-wave in Figure 1. The range of the movement from A to D is the benchmark for Fibonacci expansion. Adding the numerical range of the Fibonacci ratio of this movement, plus the level of C (horizontal line in the figure), gives the target for D.
Figure 1. Fibonacci expansion
By observing the upward movement of A-B and the downward movement of B-C, it is possible to predict the development of C-D and beyond. In the example shown in Figure 1, The C leg begins with a rally first to the 100.0% mark before a decline/short-term pullback to 78.6% is seen thereafter. Thereafter the C leg completes by pushing beyond the 100.0% to reach the start of the D(1) leg.. This is followed by another fall after exceeding 100.0% before a rise toward the 161.8% level of D(2).
2. Combining Fibonacci tools for analysis
Figure 1 shows a decline after the A-B-C-D(1) movement. Fibonacci Retracement can be used to predict the target of this decline. Fibonacci tools can be used to identify potential important price targets after several movements. Figure 2 shows the use of Fibonacci Retracement in the A-D(1) movement.
Figure 2. Using Fibonacci retracement.
At this point, the 38.2% retracement line (yellow) level is the same as the 61.8% expansion line (green), indicating the possibility of a rebound. In fact, this rebound developed and almost reached the 161.8% level, as shown by the expansion. Additionally, the downward target from that point also rebounded at the 23.6% retracement (red) and 100.0% expansion (black).
As demonstrated above, significant targets can emerge when multiple expansion lines overlap with retracements.
Summary
Key takeaways about the Fibonacci tool are as follows:
- Fibonacci retracement levels are used to identify potential support and resistance levels.
- Key percentages of this tool include 23.6%, 38.2%, 61.8%, and 78.6%.
- These levels help traders determine the levels for entry orders, stop-loss, and price targets.
- Fibonacci retracement levels are often used with other technical analysis tools such as the Relative Strength Index (RSI) and Bollinger Bands to enhance trading strategies.
Apart from the Fibonacci tool, there are many other technical analysis tools you can learn and use, such as correlation tool, sentiment tool, and currency strength tool. Incorporating these tools as part of your trading plan will enable you to analyse the markets more precisely and enhance your prop trading performance.
Besides tools and research, the journey to becoming a successful prop trader gets easier when you engage with fellow traders like yourself. Interacting with other traders can sharpen your skills and motivate you in your prop trading journey. A good community of traders may just make a difference to you passing the prop trading evaluations and becoming a funded trader.
If you’re seeking like-minded traders, why not join our OANDA Prop Trader Community? When you join the community, you'll get to participate in discussions, obtain expert insights, and earn coins that you can use to redeem rewards.
Start trading smarter by joining our community now.
