Market technicians have been using Fibonacci levels to identify turning points as well as determining price objectives for years. We focus in on them because of the fact that they are so widely used and monitored by analysts of all sizes, especially key market movers. Most trading platforms come with a Fibonacci extension drawing tool that allows you measure the length of a price wave and identify the proper extensions with ease.
We use Fibonacci levels only in conjunction with support and resistance. We will rarely enter a trade based solely on a Fibonacci retracement. If a significant Fibonacci level is present at a significant support/resistance level, the probability of a trade’s success becomes much higher.
3 Fibonacci retracements are used in our analysis: .236 .382, .50, .618, and .764.
Alot like in the identification of support/resistance levels, Fibonacci levels must be clear to define. Unlike in the definition of support and resistance levels, there might be several different ways to draw a Fibonacci extension. If ambiguity exists over a proper way to draw the extension then we prefer not to use them at all.
Also in line with the definition of support and resistance levels is the concept of time. Fibonacci extensions drawn over higher timeframes hold much greater significance than those drawn on smaller timeframes. For our longer-term purposes, we generally do not look at Fibonacci extensions on anything less than a 4hr timeframe, though they certainly maintain value on shorter timeframes, as well. Another simple way of explaining it is that Fibonacci extensions drawn from larger waves hold much greater significance than those drawn from smaller waves.
To draw a Fibonacci extension in uptrend turned downtrend, connect the highest high of the wave with the lowest low. To draw a Fibonacci extension in a downtrend turned uptrend, connect the lowest low of the wave with the highest high.
You can also calculate these levels manually, in order to more precisely define the level by doing the following:
(highest high – lowest lowest low)*.50
If we take a look at the chart of USD/CAD below, we can clearly see that the price range around 0.9718had been used as both support and resistance on the first wave down and the first wave up. When this wave completed its cycle and began to correct, this level also came in line with a .50 Fibonacci extension. When price finally hit it, it served as a very significant market turning point, good for several hundred pips on its move back up. This is the true definition of a “No Brainer Trade”. Under normal market conditions, our confidence level would be way above average on this one.
Again we don't enter trades based solely on Fibonacci retracements. Historical support and resistance must be present in order for us to enter a trade. Fibonacci retracements can also be used as a guide in areas where support and resistance levels might be difficult to identify, as their significance does not go unnoticed. Commonly, in areas of price consolidation, we will use them in order to identify the most significant market turning points. Ultimately, they reinforce these levels and greatly increase your trade's chances of success.