The cryptocurrency industry is known to be quite volatile, and it can be hard to navigate, especially for new traders. As such, having an in-depth understanding of market conditions and movements is the key to a successful crypto trading career.

One of these popular tools is Fibonacci retracement, used for predicting price movements. Applying this tool helps traders identify potential reversal points in price trends, and support and resistance levels. As such, traders need to learn how it works and how to apply it in their trading strategies alongside other trading tools.

What Is Fibonacci Retracement?

The Fibonacci sequence is a sequence of numbers where each subsequent number is gotten by adding the last two numbers. The sequence starts with 0 and 1, so following the rules of the series would be 0, 1, 1, 2, 3, 5, 8, 13, and so on. Fibonacci retracement levels are based on this sequence, and they help traders pinpoint possible support and resistance points between two major price points, such as a high and a low.

These levels are represented by horizontal lines on price charts, and each line reflects a percentage from the Fibonacci sequence. Analyzing these levels allows traders to determine not just how much a price has moved from its previous trend, but also gain insights into any other potential turning points.

This approach gained popularity among traders because fibonacci numbers can be found anywhere in nature. For example, the size of any chamber in an open seashell is the same as the sum of the two chambers before it. In the case of flower heads, its seeds germinate from the centre and spiral outwards, and each value is equal to a Fibonacci number.

Seven Fibonacci retracement levels are used for trading, including 0%, 23.6%, 38.2%, 50%, 61.8%, 78.6%, and 100%. The 50% level isn’t an official Fibonacci ratio, but it serves as the average retracement level. An example of a Fibonacci retracement is a stock rising by $10 and then falling back to $7.64; the difference between both prices is $2.36, which indicates a 23.6% retracement.

How Does Fibonacci Retracement Work?

The Fibonacci retracement tool is a handy resource for traders looking to spot potential support and resistance areas after significant price movements. It overlaps seven horizontal lines on a price chart, representing key retracement levels. These levels include 0%, 50%, and 100%, corresponding to the lowest, average, and highest points of a trend, along with additional percentages from the Fibonacci sequence: 23.6%, 38.2%, 61.8%, and 78.6%.

To use the Fibonacci retracement tool effectively, traders should first pick the highest and lowest points of a price trend within a specific timeframe that they’re interested in. The highest point before the price begins to drop becomes the 100% level. Similarly, the lowest point just before the price climbs back up is marked as the 0% level. Spotting these points is important because they show areas where the price might stall or reverse direction.

Calculating Fibonacci retracements is a straightforward process. All traders have to do is measure the difference between the highest and lowest price points, and then apply the Fibonacci ratios to the result. For example, if a price rises by 100 points, peaking at 200, and then begins to pull back, the 50% retracement level would be calculated by taking 50% of the 100-point movement (50), and subtracting it from the peak of 200, thus giving you 150. As such the 50% retracement in this context is 150.

Source: deriv.com

If a price is going up (an uptrend), retracement levels can act as support. This means that the price might fall back to one of these levels and then rise again. On the other hand, if the price is falling (a downtrend), then these levels can act as resistance points where sellers can push the prices even lower.

Market sentiments also affect retracement levels. Strong trends tend to produce smaller retracements, often between 23.6% and 38.2%. Weaker price movements, however, may linger around the 61.8% to 78.6% range. Nonetheless, the 50% and the 61.8% (golden ratio) are typically considered the most important. This is because they serve as key indicators to watch for potential reversals before the price returns to the 100% retracement level, at which point traders can expect a major price reversal.

How to Use Fibonacci Retracements For Crypto Trading

As useful as Fibonacci retracements are, they work best when used with other analysis techniques. Combining it with other tools like trend lines, volume indicators, moving averages, or the MACD (Moving Average Convergence Divergence) will give traders a clearer picture and allow them to make more informed decisions. If multiple indicators align with their signals, there is a higher chance of making a successful trade.

Since the lines represent potential support and resistance areas, traders can also use them to decide on entry and exit signals for their trades, and also set profit targets and stop-losses. For example, a trader might buy a cryptocurrency when its price reaches the 38.2% retracement level and sell when it hits the 23.6% level.

The most important step in accurately drawing Fibonacci retracement lines correctly is identifying the major price swings. If trading during an uptrend, click on the swing low and drag your cursor to the swing high. If you are in a downtrend, do the opposite. Click on the swing high and drag it all the way to the swing low.

Best Fibonacci Trading Strategies

Fibonacci levels can be applied across various trading strategies, including:

Combining With Indicators

As stated earlier, traders are advised to pair Fibonacci retracement lines with other indicators, such as the MACD or stochastic to boost their trading strategies. For example, a trader might decide to enter the market when the MACD shows a crossover and the price hits a key Fibonacci level at the same time. The combined signal suggests a strong trend is developing, thus giving the trader more confidence in their decision.

Moreover, using indicators like relative strength index (RSI) or stochastics at Fibonacci retracement levels can help traders spot buying or selling exhaustion, and also signal an incoming reversal. These tools help traders determine if an asset has been overbought (too many people buying the token) or oversold (too many people selling). As such, when the RSI or stochastics show that an asset is overbought or oversold when the price is close to a Fibonacci retracement level, it may mean a change in price direction.

Support and Resistance

Fibonacci levels can also help confirm support and resistance levels you’ve found in previous highs and lows. When the Fibonacci levels align with these areas, it confirms the validity of potential price movements.

Moving Averages

A moving average is a common trading tool that calculates the average price of an asset over a specific period of time. It updates continuously with new price data, making it easier to spot trends by reducing noise from short-term price fluctuations. Adding moving averages to a Fibonacci retracement analysis can highlight strong reversal points. For example, if the price pulls back to a 50% Fibonacci level at the same time it crosses a 50-day moving average line, it may indicate a high possibility of a trend reversal.

Candlestick Patterns

Candlestick patterns near Fibonacci levels can also provide additional confirmation on possible trend reversals. For example, an upward-moving price movement at the 61.8% level might indicate the price may start going upward again.

What’s more, Fibonacci retracement also serves as a popular trend-trading tool. Essentially, when the price decreases a little during an existing trend, it can sometimes bounce back up once it reaches one of these retracement levels. As such, these lines can help traders identify where these reversals might happen.

Limitations Of Using Fibonacci Retracement Levels

Retracement levels should not be used as an absolute solution. Even if retracement levels highlight potential support or resistance areas, prices are so volatile that they may not stop after reaching a retracement level. This is why using other confirmation signals alongside the retracement lines is advisable.

People also have a problem with the amount of retracement level lines used today. Because of the sheer amount of retracement levels, there is an increased likelihood that prices will react to at least one of them. Coupled with the volatile nature of the crypto market, traders often find it difficult to determine which specific level will be relevant at any given time. As such, when a trade fails, it’s easy for traders to second guess themselves and blame their loss on picking the wrong Fibonacci retracement level.

Conclusion

The extra information Fibonacci retracement levels provide allows traders to make more strategic decisions. However, it is important to note how volatile the crypto market is. As stated earlier, Fibonacci retracement levels should not be used as just a confirmation tool, especially if you aren’t using any other indicator to support your decision.