How to use Fibonacci retracement tool effectively

What is a Fibonacci retracement?

The Fibonacci retracement tool is used to assist in identifying support and resistance levels during countertrend moves (retracements, pullbacks) to assist in finding potential support levels in uptrends and resistance in downtrends. In addition, it can be used for targets for counter trend trading. This article focuses on using the tool for trading in the direction of the trend.

Retracement levels are derived mathematically based on the prior swing that is being measured. Once a trend high or low is established the retracement tool can be used. Retracement levels used in the tool are derived from the Fibonacci series of numbers where each number in the series is the sum of the two preceding numbers. Read more in the article: Why The Fibonacci Indicator Is Important.

Fibonacci number series starting with 0:

As the series progresses the ratio between two adjacent numbers gets closer to the golden ratio of 1.618. The Golden ratio (phi) is a mathematical constant that appears in a variety of natural and human phenomena. Since human decision making is behind all market activity it also works in markets. Golden ratio relationships are found throughout the human body, in the self-organized structure of a hurricane, and the spiral of galaxies, to name a few examples:

The 50% level is not a Fibonacci ratio, but it is a common retracement ratio that originates from the Dow Theory, while 61.8% is related to the golden ratio as it is the reciprocal (1/1.618):

The 38.2% ratio comes from dividing a number in the series by the number two places forward. Ex. 144/377 = 38.2% (1/1.618)

The first ratio used, 23.6% is the result of taking a number in the series and dividing it by the number three forward. Ex. 89/377 = 23.6%

How to draw Fibonacci retracement levels in MT4

To draw the Fibonacci retracement tool, we first need to determine whether we are looking for support or resistance based on the preceding trend. Once identified, click the Fibonacci icon on the top toolbar of MT4. Once the tool is active, left click and hold down at the bottom of the trend and move the tool to the top of the trend and then let go (opposite for a downtrend). The ratios will then show up on your chart. Editing is possible, discussed later, if you want to change color, line thickness or style, or the ratios.

How to draw Fibonacci retracement levels in MT4

If we are looking for support, we are anticipating a pullback from a prior advance in which case we need a trend high and low identified to draw the tool. In this example of the EUR/USD we start the tool at the bottom trend and bring it up to the top of the trend and let go. You can see how the price stalled around the 23.6% level on the way down, went through the 50%, until finding support around the 61.8% level.

How to draw Fibonacci retracement levels in MT4

In this next EUR/USD example we are looking for resistance as we anticipate a decline. First, identify the downtrend. Start the tool at the top of the trend and move down to let go at the bottom of the trend. You can see on the way up that price stalled at the 23.6% level but did break through before rising to the 38.2% level and stalling.

How to draw Fibonacci retracement levels in MT4

Fibonacci retracement levels use cases

Using the Fibonacci retracement tool in an uptrend

Here, we look at the development of an uptrend and where Fibonacci analysis could have been utilized. Starting from the bottom of the trend the retracement tool is drawn from the low to the high. The GBP/USD retraced to the 50% zone (doesn’t have to be exact) before the stronger force kicked in and prices continued to rise.

Using the Fibonacci retracement tool in an uptrend

Next, we look at the second swing and measure low to high. During this retracement support was seen at the 38.2% level. We can say then that momentum is improving as the first retracement was deeper. This means that buyers are stepping up earlier in the retracement, compared to the previous swing retracement, to support price.

Using the Fibonacci retracement tool in a downtrend

This next example looks at the evolution of a downtrend and use of Fibonacci analysis. In a downtrend we are looking for areas of possible resistance that may present shorting opportunities. First, a breakdown occurs on a move below the blue horizontal. Then a downtrend (within a larger trend) is chosen. In this case, the retracement of the downtrend comes off the low at 0 on the Fibonacci tool. The retracement almost reached the 50% level as more aggressive selling took hold leading to a bear trend continuation.

Using the Fibonacci retracement tool in a downtrend

The market keeps falling and we continue to look for a short entry on a retracement.

Using the Fibonacci retracement tool in a downtrend

Here, we see that the retracement reached the 50% zone before meeting resistance and reversing back down.

And then again below, a retracement to the 50% on a new trend measurement before trend continues.

Using the Fibonacci retracement tool in a downtrend

How to use Fibonacci retracement tool effectively

What trend do you want to measure?

There is no absolute answer to this question. It will depend on what the trader is trying to accomplish when looking to identify possible support and resistance. Whether it is the Fibonacci tool that is being used or other methods to identify price levels, the idea is the same.

Advantage of Fibonacci confluence?

The identification of retracement levels from the Fibonacci tool can provide greater value when multiple trend measures identify similar price zones, referred to as Fibonacci confluence. In this next example we’re looking at a 1-Hour chart and recent resistance.

Three measures are drawn starting at each dominant swing high (1) and drawn to the same low (2) for each. In addition, colors and line style are changed in the Fibonacci tool properties for clarity. Each measure identified a similar price level but with different ratios. Instead of one indication of support there are three thereby increasing the potential significance of the level.

USD/JPY chart

Assessing relative strength with the Fibonacci tool

Trends by their nature move forward, either up or down, and then retrace part of the advance before the dominant direction takes hold again. In an uptrend, it would be fair to say that the shallower the retracement the stronger the buying pressure. If a pullback to the 38.2% level occurs followed by a resumption of the uptrend, the pair is showing greater strength than a trend that retraced to the 61.8% level before continuing. This is one way to compare relative performance between different pairs.

Let’s look at two Yen pairs on the 30-minute time frame, assuming other characteristics are equal. In each chart we’re analyzing the recent uptrend and degree of retracement. The AUD/JPY retraced to the 50% level before advancing while the EUR/JPY turned back up at the 38.2% retracement. Based on those results alone we can say that the EUR/JPY is exhibiting greater relative strength.

AUD/JPY chart

EUR/JPY chart

It is the opposite situation in a downtrend. The weaker or lower the retracement, the more significant the selling pressure.

Improving effectiveness of the Fibonacci retracement tool

Any technical analysis observations are enhanced when there is confirming analysis. A retracement level is going to potentially be more significant if there is confirming analysis such as prior support or resistance, a moving average at similar price, and so on.

There is a concept in technical analysis called the weight of evidence. Each element of analysis is looked at individually to see what the evidence is telling us. If the evidence is clearly, bullish, or bearish, then there might be an action to take. If not, there is greater risk the future price action won’t go as planned.

In this next chart support is seen at the 38.2% retracement, confirmed by the horizontal from prior support, as well as the 200-Day moving average. Three pieces of evidence indicating support.

GBP/USD chart

Changing properties of the Fibonacci tool in MT4 for visual clarity

To adjust the properties in the Fibonacci tool first draw a retracement on a chart. Then, double left click on the tool trendline to highlight it. Next, right click and go to Fibonacci properties.

Changing properties of the Fibonacci tool in MT4

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