A retracement level is the price at which a stock or cryptocurrency tends to see a reversal in its trend. Fibonacci retracement is a popular tool in technical analysis that helps determine support and resistance levels on a price chart.
What Are Fibonacci Retracement Levels?
Fibonacci numbers are a series where each number equals the sum of the two previous numbers. The most basic series is: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377 etc.
When it comes to technical analysis, investors use Fibonacci Replacement Levels, expressed as percentages, to analyze how much of a previous move a price has retraced. The most important Fibonacci Retracement levels are: 23.6% 38.2%, 50% and 61.8%.
Some analysts refer to 61.8% as “the golden ratio,” since it equals the division of one number in the series by the number that follows it. For example: 8/13 = 0.6153, and 55/89 = 0.6179.
The other Retracement levels reflect other calculations: Dividing one number by the number three places to its right equals 23.6%. For example: 8/34 = 0.2352. Bitcoin traders often use 78.6%, which is the square root of 0.618,
Some prefer the 0.618 and 0.382 levels because these are the retracement levels analysts believe are most likely to generate a trend reversal. These levels are considered inflection points where fear and greed can alter price action. When an asset is trending upward but loses momentum, it’s possible that a pullback to the 0.618 price level could result in a bounce upward, for example.
How Does Fibonacci Retracement Work and What Does it Do?
There are several theories as to why the fibonacci retracement works. Some of these include:
• Fibonacci price levels reflect the effects of extreme fear and greed in the market. To use this to their advantage, traders might buy when people are panicking and sell when others are getting greedy.
• Fibonacci patterns are often observed in nature as well as in mathematics. For example: fruits and vegetables. If one would look at the center of a sunflower, spiral patterns could appear to curve left and right. Counting these spirals, the total often is a Fibonacci number. If one could divide the spirals into those pointed left and right, then two consecutive Fibonacci numbers could be obtained. Therefore, it’s thought that these patterns may be important in financial markets as well.
• The law of numbers: If a greater percentage of people practice Fibonacci crypto trading, then the likelihood of its accuracy increases.
At its core, a Fibonacci retracement is a mathematical measurement of a particular pattern. When it comes to Fibonacci in crypto, traders try to apply these patterns to price action to predict future price movements.
Who Created Fibonacci Retracements?
While traders commonly use Fibonacci in crypto today, the number sequences pre-date the invention of cryptocurrency by many centuries. Fibonacci numbers are based on the key numbers studied by mathematician Leonardo Fibonacci (or Leonardo of Pisa) in the 13th century, although Indian mathematicians had identified them previously. He was a medieval Italian mathematician famous for his “Book of the Abacus”, the first European work on Indian and Arabian mathematics, which introduced Hindu-Arabic numerals to Europe.
Formula
In an uptrend or bullish market, the formulas for calculating Fibonacci retracement and extension levels are:
UR = High price – ((High price – Low price) * percentage) in an uptrend market; where UR is uptrend retracement.
UE = High price + ((High price – Low price) * percentage) in an uptrend market; where UE is an uptrend extension.
For example: A stock price range of $10 – $20, could depict a swing low to swing high.
Uptrend Retracement (UR) = $20 – (($20 – $10) * 0.618)) = $13.82 (utilizing 0.618 retracement)
Uptrend Extension (UE) = $20 + (($20 – $10) * 0.618)) = $26.18 (utilizing 0.618 retracement)
If a stock pulls back $13.82 could be a level that the stock bounces back to reach higher levels than its swing high price, e.g. $20. In an uptrend, the general idea is to take profits on a long trade at a Fibonacci price extension Level ~ $26.18.
What Does a Fibonacci Retracement do?
Markets don’t go straight up or down. There are pauses and corrections along the way. To buy stocks in an uptrend, one would look to get the best price possible.
Some traders use Fibonacci Retracement to determine how much a stock could pull back before continuing higher. Traders can use these retracement levels to find optimal prices at which to enter a trade.
A swing high happens when a security’s price reaches a peak before a decline. A swing high forms when the highest price reached is greater than a given number of highs around it.
Swing low is the opposite of swing high. It refers to the lowest price within a timeframe, usually fewer than 20 trading periods. A swing low occurs when a lowest price is lower than any other surrounding prices in a given period of time.
Support and Resistance
Support is the price level that acts as a floor, preventing the price from being pushed lower, while resistance is the high level that the price reaches over time. Analysts often illustrate these as horizontal lines on a graph.
A support or resistance level can also represent a pivot point, or point from which prices have a tendency to reverse if they bounce (in the case of support) or retreat (in the case of resistance) from that level.
Learn more: Support and Resistance: What Is It? How To Use It for Trading
Limitations of Fibonacci Retracement
Fibonacci retracements in crypto or other markets may be slightly predictive. But over relying on them can be counterproductive for reasons such as:
• Fibonacci retracements, like any other indicators, could be used effectively only if investors understand it completely. It could end up being risky if not used properly.
• There are no guarantees that prices will end up at that point, and retrace as the theory indicates.
• Fibonacci retracement sequences are often close to each other, therefore it may be tough to accurately predict future price movements.
• Using technical analysis tools like Fibonacci retracements can give investors tunnel vision, where they only see price action through this one indicator. Assuming that any single indicator is always correct can be problematic.
A Fibonacci retracement in crypto trading could wind up being even less predictive than in other financial markets due to the extreme volatility that cryptocurrencies often experience.
Fibonacci Retracements and Bitcoin
Fibonacci retracements can also be used for trading cryptos such as Bitcoin (BTC), similarly to how they’re used in stocks. In this case, one would use the levels 23.6%, 38.2%, 50%, 61.8% and 78.6% to determine where the cryptocurrency price might reverse.
Crypto prices are very volatile, and leverage trading is common. Leverage is the use of borrowed funds to increase the trading position, beyond what would be available from the cash balance alone. Therefore, it can be important to have some reference as to when the price could reverse, to not incur major losses.
Using the Fibonacci Retracement Tool to Trade Cryptocurrencies
In order to get started with a Fibonacci Retracement Tool, a trader could find a completed trend for a crypto, say, Bitcoin, which could either be an uptrend or downtrend.
Below are some steps on how to use Fibonacci retracement tool:
1. Determine the direction of the market. Is it an uptrend or downtrend?
2. For an uptrend, determine the two most extreme points (bottom and top) on a crypto price chart. Attach the Fibonacci retracement tool on the bottom and drag it to the right, all the way to the top.
3. For a downtrend, the extreme points are top and bottom and the retracement tool could be dragged from the top to the bottom.
4. For an uptrend or downtrend, one could monitor the potential support levels: 0.236, 0.382, 0.5 and 0.618.
Recommended: Crypto Technical Analysis: What It Is & How to Do One
Fibonacci Retracement Example for Bitcoin
In December 2017, Bitcoin fell from $13,112 to around $10,800, within a short timeframe. After that, it rallied up to $12k twice, but did not break above that level until 2021. That indicates a bearish pattern, as it couldn’t break above its previous high. In technical analysis it is called a double top.
On the Fibonacci tool, the $12k resistance point coincided with the 50% level of retracement. When the price could not reach this level, it started to fall again. In this scenario, traders using Fibonacci Retracement might consider this a good time to exit a long position or establish a short position. A short trade is based on the speculation that the price of Bitcoin is going to fall.
By February, 2018, the trade materialized as Bitcoin continued its downtrend falling all the way to $9,270. The short trade would have worked and traders could have realized a profit from using the crypto Fibonacci Retracement tool, although those who managed to HODL for years after that would have made even more.
The Takeaway
The Fibonacci Retracement tool can help identify hidden levels of support and resistance so that analysts can better time their trades. Analysts believe this tool is more effective when utilized with types of cryptocurrency that have higher market-capitalization, like Bitcoin and Ethereum, because they have more established trends over extended time frames.They consider it less effective on cryptocurrencies with a smaller market capitalization.
FAQ
Does Fibonacci retracement work with crypto?
While the Fibonacci retracement tool is traditionally used for analyzing stocks or trading currencies in the forex market, some analysts believe it is also helpful in determining a crypto trading strategy.
How accurate is fibonacci retracement?
In crypto, Fibonacci retracement levels are often fairly accurate, although no indicator is perfect and they are best used in combination with other research. The accuracy levels increase with longer timeframes. For example, a 50% retracement on a weekly chart is a more important technical level than a 50% retracement on a five-minute chart.
What are the advantages of using fibonacci retracement?
Here are some benefits of using Fibonacci Retracement.
• Trend prediction. With the correct setting and levels, it can often predict the price reversals of bitcoin at early levels, with a high probability.
• Flexibility. Fibonacci Retracement works for assets of any market and any timeframe. One must note that longer time frames could result in a more accurate signal.
• Fair assessment of market psychology. Fibonacci levels are built on both a mathematical algorithm and the psychology of the majority, which is a fair assessment of market sentiment.
Photo credit: iStock/HAKINMHAN
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