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.

Fib levels are drawn by connecting turning points

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:

1. Not all fib levels play a role at the same time.
2. Hindsight shows us price stopping at fib levels precisely but we cannot predict which one price will stop at.

Some fib levels work well at times but price can penetrate suddenly

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“.

In a well entrenched trend, price is not able to reach deep retracement levels because trend traders are excited, counter-trend traders are fearful

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:

1. 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.
2. 100.0 fib retracement often contributes to the formation of triple bottoms, triple tops, double bottoms and double tops.

Deep retracement to levels like 76.4 and 100.0 happen because one group of traders did not realise trend changed and the other group is willing to wait

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.

Real examples of Fibonacci application

June 2013 – N225, HSI, STI price action rejects Fib ratios

When monthly price charts of the three regional stock market indices namely Nikkei 225, Hang Seng Index and Straits Times Index are put together, there are common elements:

1. The height of these stock market indices were printed in 2007 so they did not recover from the great financial crisis that is associated with the US sub-prime, collapse of Lehman Brothers and the AIG bailout.
2. Until all three indices beat their own 2007 high, they are all retracing the 2008 – 2009 down trend.
3. Red line in each chart shows a major Fibonacci retracement ratio that each stock index has retraced to but not able to beat.

Nikkei 225 (N225) pin bar at 76.4 fibonacci retracement ratio

1. Although the 76.4% retracement is the first attempt for the Nikkei 225, that pin bar printed by the end of May shows scarily the very bearish price action.
2. The longer the tail, the stronger the sentiment that price action is conveying.
3. It may be said that a pin bar is a very significant reversal candlestick pattern. With confluence at this fib-retracement ratio, price certainly appears to achieve climax in May.
4. Blow-off top

Hang Seng Index (HSI) re-tests 61.8% fibonacci retracement ratio

1. Hang Seng Index does not retrace as much as Nikkei 225 but what is prominent – this 61.8% Fib-R ratio was visited at least one other time back between 2010 – 2011.
2. The resistance of this 23700 level must be quite strong since price hovered at this level for as long as 7 months back early 2011. The longer the duration, the more significant the resistance. (See ‘Significant support and resistance levels are stronger: USDJPY case study‘)

Straits Times Index pin bar, bull trap, 76.4% Fibonacci ratio

1. Straits Times Index does a bull trap at the 76.4 Fib ratio.
2. Back late-2010, there was a near test.
3. Price candle is a pin bar albeit short tail.
4. But with confluence and when printed on monthly chart, a short-tailed pin bar should still have plenty of significance.
5. Wash N Rinse.

August 2013 – Fibonacci Retracement Levels scores hat-trick with Hang Seng Index

61.8% Fibonacci Retracement Level resists Hang Seng Index on Monthly Chart

First resistance was encountered late 2010 till early 2011 and then re-tested early this year. First goal.

Fibonacci Retracement Level of 61.8% resists Hang Seng Index on Monthly Chart

76.4% Fibonacci Retracement Level rules the 2013 market correction

Second goal. This level complied with the June 2012 – February 2013 rally.

2013 market correction complied to 76.4% Fib Retracement

76.4% scores hat-trick in May on smaller pattern

Third goal!

This 76.4% retracement was made on a smaller pattern

August 2013 – Another hat-trick: 76.4% Fibonacci Retracement Levels predicts three major turning points for Straits Times Index

76.4 good predictor of major turning points for Straits Times Index

Evidence #1 – Market Correction following Tech Bubble

1. Straits Times Index rallies from bottom of Asian Financial Crisis to top of Tech Bubble.
2. Market subsequent corrects following the Tech Bubble burst and then 9-11. Found support at 76.4 percent fibonacci retracement.
3. Subsequently this bottom was tested because of the SARS Epidemic and found valid.

Evidence #2 – Market Correction following Lehman and AIG crisis

1. Market rallied to new highs in 2007 but subsequently collapsed following US Subprime Crisis.
2. Support was found in 2008 and vindicated in 2009 when the Straits Times Index got supported at 76.4 percent fibonacci retracement level drawn from 1998 low to 2007 high.

Evidence #3 – 76.4% resistance despite central banks massive stimulus around the world; solid growth numbers

4 tips to use Fibonacci Retracement Levels for trading

1. Recognise that Fibonaccis are very powerful phenomenon used for trading; there are very strong market psychology involved at important fibonacci retracement levels.
2. Be acquainted with the best way to trade fibonacci retracement.
3. Practice discovering fib retracement levels by looking at major price patterns; repeating the drill of drawing from high to low, low to high.
4. Fib levels are meant to be observed. While they have stopping power, price levels may overshoot sometimes. So fishing by placing orders to be filled at key fib levels are a poor way to trade.

User tip for MT4: How to make your Fibonacci Retracement and Extension tools display price values

Tiong Hum Soh

Director, TerraSeeds Market Technician Pte Ltd. Trader, investor. @sohtionghum was picked ‘Top 70 Forex Twitter in 2015’. Operates multiple strategies.

“Dear reader, I do not have a financial license to give advice. I do not know you the reader. Your financial objective and risk tolerance may be different from mine. I am not responsible for any consequence of your action.