What is the Fibonacci Retracement Tool?
There are mathematical relationships between a trending wave and the pullback that follows it. The mathematics are based on the “golden ratio” and Fibonacci numbers that show the proportionality of one price wave to another. Such relationships are found in how we perceive beauty, how galaxies form, and how prices in financial market oscillate [see How To Swing Trade ETFs ].
The Fibonacci Retracement tool is drawn over a trending wave to provide estimates on where the following pullback is likely to stop, and where the trend will resume. The most watched Fibonacci Retracement levels are 0.236, 0.382, 0.500, 0.618 and 0.786, with the most popular being 0.382 and 0.618, although 0.236 and 0.786 also appear often, as later examples will show.
These are percentages indicating how much of the prior trending move is being retraced. If an ETF rallies $1, and then pulls back $0.38, that is a 38% (0.382) retracement of the rally. Some charting platforms show the Fibonacci levels as decimals, others as a percentage. Similarly, if an ETF drops $1 and then rallies $0.62, that is a 62% (0.618) retracement of the prior drop. Investors should be aware that this indicator is most useful on high-volume ETFs, as very low-volume ETFs may be prone to erratic movements produced by a small group of traders [see 17 ETFs For Day Traders ].
Select the Fibonacci Retracement tool in your charting or trading platform and apply it by extending the tools two points to the high and low of the most recent price wave. During an uptrend, put the 0.0 level at the wave high, and the 100 level at the low; likewise, for a downtrend, place 100 at the top of the wave and 0.0 at the bottom.
Figure 1. shows a chart* of the iShares Core S&P 500 ETF ( IVV A- ) on which the Fibonacci Retracement tool has been applied to the most recent wave of an uptrend. The Fibonacci levels mark potential areas of support.
*Note that all chart examples were created using FreeStockCharts.com:
As the price declines after the wave higher, it pauses at the 61.8 level, but then continues to drop. Ultimately, 78.6 is the level that supports the price and is the starting point of the next move higher in the trend. Once new waves begin to form, Fibonacci tools from prior waves are deleted to avoid chart clutter [see also 5 Most Important Chart Patterns For ETF Traders ].
Interpreting Fibonacci Retracements
Typically, the price of an ETF will pull back to one of the retracement levels, and experience a consolidation or a reversal back in the direction of the overall trend. The levels are only a guide for where the pullback is likely to stop and for the trend to resume, as the price may over or undershoot a level. Figure 1. above is a good example; the price pauses at the 61.8 level, but then continues to drop to the 78.6 level, overshooting it slightly.
advance we don’t know which Fibonacci Retracement level will stall or reverse the pullback. By looking at the overall strength of the trend, certain levels do become more likely, though. During a very strong trend, pullbacks are typically shallow, stopping at the 38.2 or even the 23.6 level. During normal rhythmic trends, a pullback of 50% or 61.8% is common. During weak trends, or when a trend is over-extended, a pullback of 78.6% is common [see How To Take Profits And Cut Losses When Trading ETFs ].
Figure 2. displays a choppy uptrend, followed by a strong correction of nearly 78.6% of the prior wave higher in the iShares Russell 2000 Index Fund ( IWM A- ).
Figure 3. shows how the trend continues to unfold. As the price picks up momentum, the pullbacks become smaller as buyers scramble in on retracements hoping not to miss another strong surge higher; for this strong move, the 23.6 level provided support.
Basic Fibonacci Retracement Strategy
In an uptrend, buy during a pullback when the price stalls at one of the Fibonacci levels and then begins to move back to the upside. In a downtrend, sell or short during a pullback when the price stalls at one of the Fibonacci levels then begins to drop again.
For an uptrend, place a stop-loss just below the Fibonacci level that stopped the pullback, or just below the next Fibonacci level, to allow for a little more flexibility in price movement. When it comes to downtrends, place a stop-loss just above the Fibonacci level that just stopped the pullback, or just above the next Fibonacci level to give a bit more. Figure 4. shows how this approach could have been used for trading a downtrend in SPDR Gold Trust ( GLD A- ).
Determining whether the trend is strong or weak will help traders determine which Fibonacci level is most likely to provide an entry point. If the price movement is quite strong, retracements are likely to be 23.6% to 50%; weaker trends, or trends that have been in place for many waves, will likely see retracements of 61.8% or 78.6% [see also 3 ETF Trading Tips You Are Missing ].
If the price reaches the 100 level, that means the price retraced the entire prior wave and shows that the trend is in jeopardy.
Fibonacci mathematics can also be used to establish profit targets using what’s called a Fibonacci Expansion tool.
The Bottom Line
Apply the Fibonacci Retracement tool to price waves on any timeframe, from monthly charts down to one-minute charts. Use the tool to see how far a pullback is likely to retrace after another trending wave begins. Remember, there is no guarantee the price will stop at a level just because it is shown on the chart. Fibonacci Retracements are a guide, meaning you shouldn’t rely solely on this tool, but use it as a part of a complete trading plan.
Disclosure: No positions at time of writing.