We mentioned earlier that directional trends usually stop for retracements or corrections. Corrections can take several shapes and lengths.
A healthy correction is usually short in time and magnitude. And retraces no more than 50 percent of the prior trend.
Fibonacci retracement percentages or ratios are used to identify where are the potential reversal levels for a correction.
A tool that helps outline the main corrections ratios on a chart is the Fibonacci retracement tool. The Fibonacci retracement tool is available on all popular charting platforms. We are using tradingview as our charting platform for this technical analysis tutorial.
Without going into the details of what are Fibonacci numbers and where they come from, this has nothing to do with the trading process. We will present the main and most important Fibonacci retracement levels.
If you want to know more about Fibonacci numbers you can check this link.
Traders utilize Fibonacci retracement levels to try to identify areas where the correction of the trend might end. The most popular Fibonacci levels are:
23.6 % , 38.2 , 50% , 61.8% , 78.6%
The Fibonacci levels are expected to act as resistance or support levels.
While one of them is expected to completely halt the ongoing correction.
Remember: All Fibonacci tools should be used in conjunction with other technical tools within an overall strategy.
Applying Fibonacci Retracements
This part will explain the very basics of how to apply the Fibonacci retracement tool.
To apply the Fibonacci retracement tool you need first to identify the trend that you want to apply the tool onto. Let’s explain this through a chart example:
This is the chart of AUDUSD recently
1- You can clearly see that the price has been trending higher. The first step is to identify the start of the main trend, then the latest swing high of the trend.
2- Start from the trend start swing low and end at the latest swing high.
3- Fibonacci retracement percentages are shown on the chart now. The price is approaching the 23.6 retracement level.
4- The price broke the 23.6 percent retracement level and holds steady at the next 38.2 percent level.
5- The 38.2 acted as a support and the price actually stopped and reversed again higher to record a new high just below the latest swing high, then reversed back lower.
6- since the price recorded a new swing high, we have to readjust the Fibonacci tool towards the new swing high.
7- After readjusting to the new high as shown on image above. The price has hit the 38.2 percent retracement level again and held steady above it.
Most of the time, when trying to Identify the latest swing high, the price might only drop a little and reverses to record new highs. In this case, you have to keep readjusting to the new high until a deeper correction materializes.
Let’s have a look at another chart example in a downtrend:
The price was clearly falling in a strong down wave. We placed our Fibonacci retracement tool starting from the high of the wave towards the latest low. As seen below.
The price then extended the downside move a bit further. Therefore, we adjusted the tool to the new low. The price then retraced towards the 23.6 percent retracement level
The retracement continued higher towards the 38.2% retracement where the price started to fall again.
The down move accelerated to break to new lows.
The price recorded a new low and then bounced, we had to adjust to this new low.
Fibonacci Retracements Confluence
As you already know, trends have many lengths and they are fractal, where shorter-term trends are parts of a longer-term trend.
Therefore, you will see multiple short-term bearish trends within a longer-term bearish trend.
Therefore, you can draw the Fibonacci retracement tool for several trends at the same time.
Also, you will usually witness a confluence of Fibonacci levels near the same price, and that makes that price level worth watching.
Here are some chart examples:
The price found strong support at the confluence of the 38.2% retracement level for the longer-term trend and the 50% retracement level for the shorter trend.
There are three Fibonacci confluences in the above live chart for the EURUSD. The first two confluences were decisively broken hinting that selling pressure is strong and likely will continue. (This is the current live chart for EURUSD)
The next Fibonacci confluence is at 78.6% for the over trend and 100% for the shorter trend. That means if the price reaches there, it would have retracted all the short-term trend.
Just like retracement levels, the Fibonacci extensions are possible to support or resistance levels. They are used by traders to project price targets as well.
They are called extensions for a reason. They tell how far the price extended compared to its latest correction. Let me explain by a chart:
Let’s take it step by step,
If we had an uptrend AB, then a correction BC of trend AB. Then a new wave or trend started from point C moving higher and higher until it breaks the high at point A. We would say that the price has corrected all wave BC(100%). If the price extended further above B to reach the price at point D, then the price has extended by 200%.
It extended two times the length of BC correction.
You draw Fibonacci extensions for wave BC using the Fibonacci tool starting from point B to C.
Just like retracements, there are several extension ratios. However, I personally recommend sticking with the main ones. Key levels are the 1.1271 (127.1%) , 1.618 (161.8%) , 2 (200%) . You won’t need more than these three ratios.
Fibonacci-Based Chart Patterns
There are several Fibonacci-based patterns. However, according to my personal experience, their reliability is minimal. Only two patterns have passed our reliability requirement and will be covered in this technical analysis tutorial. The ABCD and the Three-Drive patterns.
The ABCD Pattern
The ABCD is a three-wave pattern. Two main waves and one corrective wave.
The ABCD pattern can be bearish ABCD or Bullish ABCD.
The bearish ABCD consists of an up wave AB followed by a down correction BC, and finally an upward wave CD that extends above the high of the AB wave(point B). When the price reaches point D traders look to sell the price as it is expected to reverse to the downside.
In a bearish ABCD
- The correction wave BC must end at 61.8% or 78.6% of AB.
- Then CD should end at the 127.1% or 161.8% extensions of BC.
- A reversal to the downside or a pullback should start at one of these extension levels 127.1-161.8. And this is called the potential reversal zone of the pattern.
- Ideally, if BC ends at 61.5% then expect the potential reversal zone to be at 161.8% of BC.
- If BC ends at 78.6%, then expect the potential reversal zone to be at a 127.1% extension level.
- The ideal case is not necessarily needed in my personal experience.
-Never count on ABCD patterns solely. Use other technical analysis tools to confirm a reversal.
– A bullish ABCD pattern is more effective if it forms within the context of an overall bullish trend. The opposite is true for Bearish ABCD within an overall downtrend.
– If a bullish ABCD pattern forms in a downtrend, the result is usually a correction, not a major reversal. The opposite is true for bearish ABCD in an uptrend.
This is an ideal bearish ABCD with BC retracing 61.8 percent of AB, then CD extending to 161.8.
This is an example of bullish ABCD with BC retracing 78.6 percent of AB, then CD extending to 127.1 percent.
This one is a non-ideal ABCD, where the BC corrects 61.8% of AB, and the price extends only to 127.1 to reverse direction. Therefore, do not assume that the price will always reach the 161% level. Keep your eye on the 127 level for signs of bearish reversal.
The following chart is an example of two bearish ABCD patterns that formed within the context of the longer-term trend. Two ABCD patterns formed within the context of a longer-term bearish trend had a powerful bearish outcome.
Note: Talking about retracement and extension levels, don’t be too precise with numbers. i.e. if the price reaches near a retracement or extension level, but fails to touch it with a few pips difference. That should not invalidate the pattern.
This note is valid only on time horizons above the one-hour chart. If you are trading very short-term time intervals, a few pips should count.
The Three-Drive Pattern
The three-drive pattern is one of my personal favorite chart patterns.
It is a 5-wave pattern. Three main waves and two corrections.
The three-drive pattern is very similar to the ABCD. The only difference is that there is a third main wave that extends above point D.
The same rules of ABCD apply to the three drives pattern. Expect reversal at point F.
Point F should be either the 127.1% or the 161.8% extension of the DE corrective wave.
Don’t give too much weight to whether the pattern complies with the ideal case. The most important factors are:
- Corrections should stop NEAR either 68.1% or 78.6% levels of the prior main wave.
- The extension should stop at either 127.1% or 161.8% of the latest corrective wave.
Here is a chart example:
For a detailed explanation and trading strategy, I strongly recommend that you check out the three drives pattern complete tutorial.