I don’t believe very much in technical indicators that are completely mathematical and ignore the peculiarities of a specific price chart. The Fibonacci retracement is such an indicator, but I have to admit that it works in many cases. I guess it’s a self-fulfilled prophecy and not a common situation in nature, that the advocates of the Fibonacci sequence believe. The markets in the short term are mostly human psychology and not natural environment.
The Fibonacci retracement tool is used when an already existing trend is fading and we want to have a clue about how much it will correct and where price might reverse to its prior trend.
In an uptrend we must join its lower low with its higher high (A & B in the chart below). The Fibonacci retracement tool is telling us that the new downtrend might stop on the 23.6%, 38.2%, 50% or 61.8% Fibonacci level (the 50% is not a real Fibonacci level). If the correction stops in one of these levels then it might bounce upwards before continuing the downtrend or it might reverse and make a higher high (continuation of the uptrend after the correction).
We can see in the S&P 500 chart how the Fibonacci retracement tool quite accurately predicted temporary bounces (points in red circles) as the index started correcting after reaching its higher point (B).
We can see that many times the Fibonacci retracements coincide with real support levels on the chart and that’s how the Fibonacci must be used, in combination with other technical criteria and not in isolation.
In a downtrend we must join the higher high (H) to the lower low (K) in order to have a clue about where the upward correction might stop (see chart below).
Of course bear in mind that as every indicator Fibonacci retracement many times will give a false signal. Use it with caution and in combination with candlestick reversal patterns and real supports or resistances.
En
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