The Fibonacci retracement tool is often used in technical analysis to predict possible future prices in the crypto market. It is a confirmation tool that can help you get better trading results when used with other indicators, and this is how you use the Fibonacci retracement tool in cryptocurrency trading.
What Is the Fibonacci Retracement?
Fibonacci retracement is an important technical analysis crypto trading tool that gives insight into when to execute and close trades or place orders and limits. The indicator uses percentages and horizontal lines to identify important support and resistance points during an uptrend or a downtrend. You can use it as part of a crypto trading strategy.
Price does not move in a straight line; it goes through a series of pullbacks, forming something like a zig-zag pattern. In an uptrend, for example, the price does not keep moving straight up; it moves upward and retraces before it continues the upwards movement. This pattern happens continuously within a trend.
Many crypto traders use the Fibonacci retracement tool to check for possible places where a price pullback may find support or resistance. A pullback, also known as a retracement, is a temporary reversal in the crypto market trend. It is different from a reversal in that it is only a short-term movement against the trend, followed by a continuation of the ongoing trend.
Understanding Fibonacci Numbers
Fibonacci is all about numbers, and these are the key values to watch out for.
The Fibonacci Sequence
The Fibonacci number sequence was discovered by Leonardo Pisano, who was also named Fibonacci. He documented them in his book, Liber Abaci, “The Book of Numbers,” which he published in 1202. The sequence of numbers is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.
The series is derived by adding the two contiguous numbers to form the next one. With that in mind, you can surmise that the sequence’s next three numbers will be 233, 377, and 610.
Fibonacci Golden Ratio
One of the notable things in the sequence is the ratio between the numbers. Each number is approximately 1.618 times bigger than the preceding number. The 1.618 derivation is known as the golden ratio. The term “golden ratio” is not only based on the sequence’s derivation but also because the ratio reflects in almost everything around us.
The Fibonacci numbers appear in DNA molecules, reproductive patterns, hurricane patterns, tree branches, etc. For example, looking closely at flower petals, you will discover that an intact buttercup has five petals and lilies have three, which are Fibonacci numbers.
Using Fibonacci Numbers in Cryptocurrency Trading
Just as the Fibonacci numbers are obvious in everything around us, so are they in trading. Crypto traders use the Fibonacci retracement tool to identify support and resistance points while trading. The tool is made up of numbers derived from the differences between the numbers in the sequence. The numbers include 0.236, 0.382, 0.618, and 0.786.
We already described how the ratio 0.618 is derived: by dividing a number by the preceding one. Dividing a number by another two places higher in the sequence will give approximately 0.382. For example, dividing 21 by 55, 89 by 233, and 233 by 619 will give us approximately 0.382.
Using the same pattern, dividing a number by another number three places higher in the sequence will give approximately 0.236. Thus, the ratios 0.236, 0.382, 0.618, and 0.786 are formed from the difference between the numbers. They can also be expressed in percentages as 23.69%, 38.2%, 61.8%, and 78.6%, respectively.
Another important number usually used in Fibonacci retracement is 0.50, or 50%. It is not derived from the Fibonacci numbers, but it has been seen as an important point for likely reversal based on other theories.
From the image above, we can see that the price bounced off the 0.618 Fibonacci level, and the uptrend continued. The 0.618 Fibonacci level acted as support for the price in the chart.
Applying Fibonacci Retracement to Your Crypto Trades
The Fibonacci retracement tool is relatively simple to use. You only need to choose low and high price swings relevant to your analysis and the price at which you are trading.
Choosing the two points must be done carefully to get an accurate measurement. In an uptrend, you must attach the tool to the lowest relevant price of the low swing and connect it to the highest relevant price of the high price swing. Conversely, you must connect it to the last trend’s highest and lowest relevant prices in a downtrend. As simple as this may seem, not doing it accurately will give you the wrong result.
The chart above shows how to use Fibonacci retracement in an uptrend. We drew the line from point 1 to point 2. The two points are the important high and low before the retracement. The price then retraces and bounces off the 61.8% (0.618) Fibonacci level to continue upward.
We drew the Fibonacci line upward in the example above. In the case of a downtrend, we would draw the line downward. In other words, in an uptrend, you should draw the Fibonacci line from the low of the last relevant swing to its high. In a downtrend, it is vice versa.
The information you get from the retracement levels will help you determine possible support and resistance points, and what you do with such data depends on your trading strategy.
Using Fibonacci Retracement in Trend Trading
Many traders use the Fibonacci retracement levels in combination with the trend line and other technical indicators as a part of their trend trading strategy. They use the combination to make low-risk entries into an ongoing trend and form a confluence that helps make better trading decisions.
In trading trends, traders expect the trend line to form a resistance in the case of a downtrend, and support, in the case of an uptrend, making the price bounce off the trend line multiple times. Although there is no certainty that the trend line will serve as expected, drawing a Fibonacci retracement line can serve as an extra indicator to check for the possibility of a trend continuation after the price has reached the trendline.
The chart above shows that the price bounced off the trend line multiple times. Let’s imagine a case where the trader is unsure if the trend line would continue to serve as resistance before the third bounce in the picture above. The trend line has a confluence with a strong Fibonacci line would have propelled more confidence into the trader to execute the trade. The trend continuation that followed would not have come as a surprise.
How You Use Fibonacci Retracement Depends on Your Crypto Strategy
You can also use the Fibonacci retracement tool with other technical indicators, including candlestick patterns, oscillators, volume momentum, moving averages, etc. Some people use it with price action to trade trend reversals and counter-trend trading strategies. These traders do not wait for the price to get to the Fibonacci retracement support or resistance but rather use the levels to determine when to secure their profit. Some other people also regard the Fibonacci retracement tool as confusing and a waste of time and prefer not to use it.
We used the 61.8% Fibonacci level in all the charts we used as examples. However, the levels to use depend on your strategy. You can form your crypto trading strategy around different Fibonacci levels as it works for you. It is up to you to figure out how best to use this technical tool to get the best crypto trading result.