Market psychology at important fibonacci retracement levels
Which fibonacci retracement level is most important?
Fibonacci retracement levels or fib levels are the ratios 23.6, 38.2, 50.0, 61.8, 76.4 and 100.0. These are in fact also the most common ones because there are other levels too like 78.6 and 85.4. Some traders also round them off to whole numbers. Traders recognise that fibonacci retracement levels or ratios are very important to financial markets. Their contribution lies in technical analysis so they may be applied to discretionary trading as well as system-based trading or algorithm trading. Concepts of retracement, fibonacci ratios go hand in hand with Elliott Wave Principle and Dow Theory.
New traders who encountered fibonacci retracement levels are on the constant search for the single 'most important' level. In my personal opinion, there is no single 'most important' fibonacci retracement level. Rather which level comes to the fore has to do with timing and can only be confirmed by observing price action. However some fib levels have more meaning than others.
Some fib levels are important some of the time
New traders become obsessed with fib levels. Their idea of fib levels is "if its so powerful, can I just queue my order there?" Fibonacci retracement levels cannot be used like that. It is a bad strategy and here's why:
- Not all fib levels play a role at the same time.
- Hindsight shows us price stopping at fib levels precisely but we cannot predict which one price will stop at.
Fibonacci retracement levels can reveal market psychology
23.6, 76.4 and 100.0 are fibonacci retracement levels that have more meaning. There is a market psychology involved at each level. Therefore a trader must catch the mood of the market right in order to use these levels more effectively.
23.6 is associated with strong trends and excitement
The 23.6 fib retracement level is a shallow level. In an uptrend, bullish players are not ready to wait for more retracement instead opting to join the trend quickly. Bearish players who are against the trend do not have the strength or are fearful and so close their positions quickly. The market psychology has to do with a lot of excitement, fear and impatience. Therefore price is unable to retrace to deeper levels based on the anxiety of traders from both sides.
The 23.6 fibonacci retracement level therefore becomes very significant when markets are most bullish or bearish. The existing trend is very well entrenched is recognised by the market. The 23.6 retracement is likely to be part of the Wave 3 or Wave 5 in a dominant trend. Signs that the trend is very well entrenched include:
- Price movement becomes parabolic
- Price prints wedge pattern
At this stage a very strong feeling overcomes bullish buyers "I cannot wait anymore otherwise I will miss the entry".
76.4 and 100.0 fibonacci retracement levels are associated with reversal
These 2 levels are associated with trend reversal or beginning of new trend. In an uptrend for example, Price breaks support to make a new downtrend but bullish traders miss this sell signal. They jump in to buy when they perceive that price is oversold but do not realise that price cannot continue higher. On the other hand sellers recognise the new trend but are keen to wait for more retracement. Each higher retracement allows bearish traders to sell at a higher level. 76.4 is considered a very strong retracement. A 100.0 retracement is also a very strong retracement - strong enough to even make early bears (probably those who jumped at 76.4) doubt if they have sold too early.
It is interesting to note that:
- 76.4 fibonacci retracement levels often contribute to the formation of the right shoulder in a Head and Shoulders or Inverted Head and Shoulders chart pattern.
- 100.0 fib retracement often contributes to the formation of triple bottoms, triple tops, double bottoms and double tops.
How to use fibonacci retracement levels properly
Identifying fibonacci retracement levels is usually part of a trading strategy to identifying turning points in order to enter a with-the-trend trade. Traders must recognise that fib levels are significant but can provide hints only. The value is not 'cast in stone'. Fib levels provide hints of price zones to look for turning points. However other technical concepts such as trendlines, horizontal levels and confluence of many must come into play to decide which level is good. In addition, volatility created by policy announcements, market developments can create volatility so fib levels are only indicative and cannot be used precisely. The best technique therefore should use a mix of fib levels, confluence and observation of price action i.e. looking at sentiment conveyed by candlesticks to find entry points.
Update 01 August 2013 - 4 examples