What is Fibonacci retracement: how to trade with the golden ratio

Does it sometimes feel like you're guessing when trading crypto? Given the notoriously volatile price swings for various coins and tokens, it's certainly challenging to predict future movements. This is where technical analysis (TA) comes in handy, as TA uses historical price data and various indicators to identify potential trading opportunities.

Fibonacci retracement is one such indicator that can help crypto traders estimate where prices might find support or resistance after a significant move. From explaining what drives Fibonacci retracements to incorporating it into a crypto trading strategy, our guide will explain what Fibonacci retracements are and how you can best leverage them in your crypto trading journey.

What is Fibonacci retracement?

Fibonacci retracement is a popular technical analysis tool used in crypto trading that involves identifying key levels based on the Fibonacci sequence, which can act as potential support and resistance zones. These zones might indicate areas where the price might bounce or face selling pressure, helping traders make informed decisions before committing to a trade.

How do Fibonacci retracements work? Understanding the Fibonacci sequence

The core concept behind Fibonacci retracements lies in the Fibonacci sequence. This is a mathematical series where each number is the sum of the two preceding numbers. It starts with 0 and 1, and the sequence continues as follows:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89...

The Fibonacci sequence is fascinating because it appears throughout nature, from the arrangement of leaves on a stem to the spiral patterns in seashells. The common skeptic might wonder what this has to do with crypto trading. By taking a close look at the ratios derived from the Fibonacci sequence, we can see that specific values form when we take a ratio of two consecutive numbers in the sequence.For example:

• 13 divided by 8 equals 1.625 (approximately).

• This ratio, 1.618 (often rounded to 1.62), is known as the Golden Ratio.

Interestingly, these Fibonacci ratios (like 0.236, 0.382, 0.5, and 1.618) are believed to have a significant influence on market behavior, including crypto prices.

The theory behind Fibonacci retracements is that after a strong price move, there's a high probability the price will retrace back to a level corresponding to a key Fibonacci ratio before continuing its trend.

Key Fibonacci ratios to take note of

The most commonly used Fibonacci retracement levels are:

• 0.236: This level represents a 23.6% retracement of the prior price move.

• 0.382: This level represents a 38.2% retracement.

• 0.500: This is the midpoint of the price move.

• 0.618: This level represents a 61.8% retracement, often referred to alongside the Golden Ratio (1.618) for its potential significance.

• 0.786: This level represents a 78.6% retracement.

Setting up the Fibonacci retracement

Now that you understand the Fibonacci sequence and key retracement levels, let's see how to use them in your crypto trading strategy. Most charting platforms offer a Fibonacci retracement tool. Here's a breakdown of the process:

1. Identify the trend

The first step is to identify the overall trend of the coin or token you're interested in. Is it trending upwards or downwards?

2. Select the peaks and troughs

For an uptrend, the peak (or swing high) is the highest price point before a retracement, and the swing low is the lowest point before the current uptrend.

For a downtrend, the opposite rings true as the peak (or swing high) is the highest point before a correction, and the trough (or swing low) is the lowest point before the current downtrend.

3. Apply the Fibonacci retracement tool

Most charting platforms allow you to manually draw Fibonacci retracements. You can do this by clicking on the peaks and troughs to automatically lay the Fibonacci retracement levels on the chart.

4. Identifying support and resistance levels

Once you've applied the Fibonacci retracement tool, horizontal lines will appear across the chart corresponding to the key Fibonacci ratios. These lines represent potential support zones during an uptrend and resistance zones during a downtrend.

Trading strategies with Fibonacci retracements

Here are some basic trading strategies you can explore using Fibonacci retracements. For this example, we'll be making use of the Bitcoin price chart to draw our Fibonacci retracement. To begin, we'll first identify the recent peaks and troughs achieved by Bitcoin. As seen in the example, we'll be using $73,787.10 and $56,555 as our swing high and swing low. This gives us an array of Bitcoin retracement levels of which we can trade upon.

Source: OKX

Buying at support

During an uptrend, if the price retraces back to a key Fibonacci level (like 0.382 or 0.618) and finds support, it might be a potential entry point to buy and establish a long position, anticipating a continuation of the uptrend.

In this case, with Bitcoin's key Fibonacci levels being at $63,137.70 and $67,204.40 for the 0.382 and 0.618 ratios, these can effectively act as the support zones at which crypto traders may consider going long if there's a sudden breakout at these price levels.

Selling at resistance

Conversely, during a downtrend, if the price rallies but encounters resistance at a key Fibonacci level, it might be a signal to sell the cryptocurrency, expecting a continuation of the downtrend.

With the above example, the 0.786 ratio seems to be a strong resistance zone for Bitcoin as prices tend to bounce off the particular zone. In anticipation of such a sell-off, BTC traders with a long position may want to consider closing their position at this key Fibonacci retracement level of $70,099.40.

Taking profit and setting stop losses

As with all forms of TA, such tools are probabilistic rather than definitive. That's why it's key to set stop loss orders to limit potential losses if the price movement goes against your trading plan. Additionally, crypto traders can consider locking in gains at predetermined levels based on your risk-reward ratio.

Based on our Bitcoin Fibonacci levels example, for risk-averse crypto traders, it's recommended to set a stop-loss order at $56,555 since this is the previous low for Bitcoin. If volatility causes Bitcoin prices to break past this locally established low, the entire Fibonacci retracement is rendered moot. As for take profit levels, the 1.618 retracement level would be an ideal zone to lock in your BTC gains given that it's a golden ratio for BTC prices that's beyond previous all-time highs. As such, traders can set take profit limit orders at $84,436.50.

It's important to remember that Fibonacci retracements are just one tool in a trader's toolbox. They should be used in conjunction with other technical indicators and fundamental analysis for a more comprehensive trading strategy. We'll cover the potential complementary trading indicators below.

Strengths of Fibonacci retracements

Fibonacci retracements are a popular technical analysis tool used by traders to identify potential support and resistance levels in the markets. Here's a summary of their strengths that highlight why they're so popular.

Identify potential support and resistance

Every trader knows the difficulty in finding a proper entry and exit. This is doubly so given the volatility of crypto prices. Fortunately, Fibonacci retracement levels can help traders clearly identify areas where the price may stall or reverse.

Versatility across timeframes and markets

Regardless of whether you're a day trader or a long-term buy-and-hold kind of trader, Fibonacci retracements can be drawn to fit your trading needs. Given their versatility, the peaks and troughs identified can be applied to any market and timeframe, making them a widely applicable tool.

Simplicity and ease of use

The concept behind Fibonacci retracements is relatively easy to understand, even for new crypto traders. As such, the easy-to-read nature of Fibonacci retracements lends to the tool's overall popularity among beginners who are still attempting to learn the ropes when it comes to TA.

Limitations of Fibonacci retracements

While Fibonacci retracements can be a valuable tool, it's crucial to understand their limitations.

Fibonacci retracements aren't crystal balls

Just because the price hovers around a Fibonacci level doesn't guarantee a reversal. Given that markets are complex and influenced by various factors beyond the Fibonacci sequence, traders may need additional indicators to confirm the reversals hinted at by the Fibonacci retracement.

Multiple retracement levels create noise

For beginner crypto traders, the abundance of Fibonacci retracement levels can create ambiguity. Since prices might find temporary support or resistance at any of these levels, it'll be a challenge to pinpoint the exact reversal point for trading if you're new to the world of crypto trading.

Subjective retracement

The placement of Fibonacci retracement levels can be subjective, depending on the chosen peaks and troughs. As each crypto trader has a different time horizon in mind because of varied trading plans, traders may miss out on potential entry and exit points.

Combining Fibonacci retracements with other trading indicators

To overcome these limitations, it's wise to complement Fibonacci retracements with other technical indicators. This could include the following.

• Moving averages: Identify the overall trend using moving averages like the 50-day or 200-day moving average. Besides providing asset prices over a fixed time period, moving averages can also act as specific trading zones in specific instances such as golden crosses and death crosses.

• Relative strength index (RSI): The RSI helps gauge if a cryptocurrency is overbought (potential for a retracement) or oversold (potential for a price increase).

• Support and resistance levels: Look for the merging of Fibonacci retracement levels and established support and resistance zones on the chart. This will give us confirmation that the asset is indeed trading based on the Fibonacci retracement levels drawn.

By combining Fibonacci retracements with other indicators and analyzing price action, you're better placed to create a robust trading strategy that allows you to trade with more confidence.

Final words and next steps

Fibonacci retracements are a valuable tool for crypto traders to identify potential support and resistance zones. By understanding the Fibonacci sequence, applying the retracement tool, and interpreting price action, you can gain valuable insights into potential price movements. However, it's crucial to remember that Fibonacci retracements are probabilistic, not definitive. Always combine them with other technical indicators and fundamental analysis for a well-rounded trading strategy. As with any trading tool, practice and experience are key to mastering the art of timing the retracement.

For more on TA, why not read up on our guides to the best crypto trading indicators to sharpen your crypto trading skills. Alternatively, you can also learn about everyday signs that hint at today's market sentiment with our take on non-technical indicators.