Understanding Pullbacks Using Fibonacci Retracements

Finding out where a pullback is likely to end is a goal in the mind of many a forex trader, there are a few different technical analysis tools traders use to try to solve this problem, perhaps the most popular of these tools is the Fibonacci retracement.

Today I’m going to give you a complete guide on how to use Fibonacci retracements correctly in your forex trading. A large number of other forex websites also have guides available on how to use Fibonacci but the majority of them will not show you how to determine which retracement levels the market has a high probability of reversing at, whilst I cannot tell you exactly which level the market is going to turn at, I can teach you how to identify if the market is going to turn at the lower fib levels i.e 23.4% -38.%  or the upper fib levels  50% 64.6%, anybody who already has knowledge on Fibonacci knows how important this could be.

We’ll begin by taking a look at what Fibonacci retracements actually are – how to draw them – how to trade them and then towards the end of the article I’ll show how to find out which levels the market is going to reverse at .

 

What Are Fibonacci Retracements ?

 

Fibonacci retracemetns are a tool used to measure how far the market has pulled back into an up or down swing. When traders draw Fibonacci levels on their charts they will watch the price action as the market hits the levels for signs of the pullback coming to an end, typically traders will use Fibonacci retracements in conjunction with other technical analysis tools like support and resistance to see if there is a confluence of factors lining up in the same place in the market.

When the market reaches Fibonacci levels traders will often use candlestick patterns as a means of entering into trading positions, overall there are four levels which make up the Fibonacci retracement tool: 23.6% – 38.2% – 50.0% – 61.8%

These four levels show you what percentage the market has moved back into the swing, if you had drawn a retracement on a up-swing and you see the market fall to the 50% Fibonacci level, it means the market has pulled back halfway of the whole up-swing.

image of fibonacci retracement on aud/usd upswing

Here’s an example of what a Fibonacci retracement grid looks like on an up-swing of AUD/USD

We’ll get into how to actually draw the levels a little later, for now just take a look at the different retracement levels in the image.

You can see the market retraced 61.8% of the up swing before continuing to advance higher, a trader who had these levels drawn on his chart would watching for signs of a reversal as the market fell into each level, if a pin bar or engulfing candle formed at one of the levels he would enter the market expecting a reversal to take place.

 

How To Draw Fibonacci Retracements

 

Drawing Fibonacci retracements is a pretty simple process, the method you use to draw retracements from up-swings and down-swings differs as I’ll now show you.

To place a Fibonacci retracement on you charts you must first select the tool from the INSERT tab found at the top of MT4 window.

Lets look at how to draw retracements on up-swings.

image of swing high and swing low on aud/usd

First you need to locate an up-swing in the market, an up-swing is characterized by a move up from one point to another without a pullback or consolidation taking place in between the move.

The image above shows a typical upswing on the 1 hour chart of AUD/USD

You can see I have marked the swing low found at the bottom of the up-swing and the swing high found at the top, these two swing points are what we will use to draw our retracement levels from.

image of drawing fibonacci grid on aud/usd

After selecting the Fibonacci retacement tool, you need to click on the swing low of the up-swing and drag the Fibonacci tool up to the swing high just like I’ve done in the image.

Fibonacci Retracements on up-swings are always drawn from the swing low to the swing high.

Do not make the same mistake as many traders and draw them from the swing high to the swing low, the levels will not be correct.

Now you know how to draw retracements on any up-swings you find in the market, lets take a look at how to do the same for downs-swings.

image of downswing on chart of eur/usd

Here’s an example of a down-swing on the 1 hour chart of EUR/USD.

The way you draw Fibonacci retracements on down-swings is by locating the swing high and swing low of the swing down, then draw your Fibonacci levels from the swing high all the way down to the swing low.

 

How To Trade Fibonacci Retracements

 

We trade Fibonacci retracements in a similar way to how we trade other technical analysis tools like support and resistance and supply and demand.

The retracement levels give us places where the market may reverse upon its return, we don’t know which of these level will end up turning the market so we must watch for price action signals when the market hits the levels to determine whether or not the market has a good chance of turning in the opposite direction.

image of fibonacci reversal on chart of usd/jpy

Here we have a down-swing with the Fibonacci retracement levels drawn on.

Notice how the market reacted to two of the levels ? First it touched the 50% level which caused a slight down-move and then it tapped the 61.8%  level which ended up causing the reversal.

Now let’s go down to the 15 minute chart to see if there were any price action signals to get short when the market hit each of these levels.

image of fibonacci reversal on 5 minute chart of usd/jpy

We can see the market reacted to both levels in a similar way.

Upon touching the 50% level the market produced a bearish engulf candlestick, while not best engulf ever seen in terms of characteristics it was still possible to place a sell trade based on this engulf.

The second level found at 61.8% of the down-swing also provided us with a bearish engulfing candle, this engulf had a better chance of resulting in a successful trade due to it not containing a large wick on the bottom of the candle. The other engulf had a slight wick on the bottom of the candle which means someone was still buying when the market fell creating the engulf, if someone is still interested in buying its a sign the up-move may not be over.

Notice how you can also see the market react to the 23.8% level before it hits the 50% level ?  There’s a simple reason why the 23.8% level doesn’t cause a reversal which I’ll explain over the coming pages.

 

The Correct Understanding Of Fibonacci

 

So far this article has been pretty similar to other articles and guides you can find online about trading Fibonacci retracements, we are going to take a bit of detour now and I’m going to explain to you why the market has a tendency to reverse at the retracement levels and how to determine which retracement levels the market is likely to reverse at.

 

Why Does The Market Turn At Fibonacci Levels ?

 

As with anything in the forex market there is a reason why the market turns upon reaching Fibonacci levels…..

If you look at online articles or read books on Fibonacci retracements you’ll see for the most part they never offer any explanation as to why the market actually turns at these levels. Why is this ?

The answer is simple…. because they don’t know why the market turns at these levels.

Everything which happens in the forex market is caused by people placing trades, Fibonacci levels are no different, the market turns at retracement levels due to traders placing trades, more specifically, bank traders placing trades against retail traders.

The Big Fibonacci Lie

 

We are going to look at an example of why the market turned at a Fibonacci level, we’ll use the beginning of the uptrend on USD/JPY for this as its easy to explain what is happening behind the scenes.

image of pullback at the beginning of usd/jpy uptrend

The image above shows the deep pullback which took place at the beginning of the USD/JPY uptrend with the Fibonacci retracement grid draw on the first swing up. A trader who has placed the Fibonacci grid on their charts will have looked at this and believed the market reversed due to it hitting the 76.8 fib level.

Unfortunately the trader is incorrect, the market hasn’t reversed due to it hitting the 76.8 level, its reversed because the market has moved down enough to make retail traders believe the downtrend is going to continue. The bank traders wanted to make retail traders place sell trades so they are able to place their own buy trades, when the retail traders have placed enough sell trades the banks place their own buy positions and the market reverses.

The market hasn’t turned because of the Fibonacci level, it’s turned because enough retail traders have gone short, it just happens to be chance the 76.8% fib level fell inline with the point where the bank traders had enough sell orders come into the market from retail traders that they could get all of their buy trades placed.

This is why the market doesn’t always turn exactly at the Fibonacci levels themselves and instead reverses in between the levels, the market will always reverse at the point where the bank traders have enough orders come into the market to carry out which ever action they wish to take, whether that be placing trades, closing trades or taking profits, the Fibonacci level itself DOES NOT cause the market to reverse.

Note:

You can see on the image the Fibonacci grid contains a fifth level which I didn’t show you earlier. I’ll release an article soon detailing the use of the 76.4% level and explain to you why its important for spotting market reversals.

 

So Fibonacci Is Basically Useless ?

Well no not exactly…..

Although the reason the market turns at retracement levels has nothing to do with Fibonacci itself they can still be used as a visual tool to measure the beliefs of retail traders in the market. If we know the market will turn due to professional traders coming into the market and either buying or selling off the retail traders who are placing traders in the direction of the retracement, then by analyzing how far back the market retraces we can determine what the bank and retail traders are currently doing.

Lets take a look at what reracements can reveal to us in trending markets.

 

Fibonacci Retracements In Trending Markets

Which Fibonacci levels the market is likely to turn at depends on how long the market has been in a trend.

If there is a long trend its unlikely for the market to make a large pullback unless the trend itself is reversing, this means when you draw Fibonacci retracements on swings which form after the market has been trending for a long time there is a high chance the market will not come back to the upper levels e.g 50.0% – 61.8% because the majority of traders will continue to place buy or sell trades in the direction of the trend even when the market is pulling back.

image of the end of eur/usd downtrend

If we look back to the end of the EUR/USD downtrend we can see how on one of the final swings lower the market only manages to reach the 23.6% level before continuing to fall. At this point in the downtrend most retail traders are selling due to how long the market has been falling, any small pullback or consolidation is used by the retail traders as an opportunity to place sell trades. People do not make rational and logical trading decisions this far into the lifespan of the trend, traders will sell just because they believe the downtrend is certain to continue due to how long it has already been going down.

So seeing the market turn at one of the lower levels – 23.6% – 38.2% in a long trend means a large amount of retail traders are placing trades in the direction of the trend and it may be possible the trend itself is coming to an end or a big pullback/consolidation is soon to take place to make all the retail traders who are participating in the trend lose money.

 

Fibonacci Retracements In Trend Reversals

 

When a trend is reversing the market will come back to either the lower levels – 23.6% – 38.2% or the upper levels – 50% – 61.8% depending on which type of reversal is taking place.

You can figure out which type of reversal is occurring if you have an understanding of how retail traders think when they are participating in a trending market.

image of trend reversal on usd/jpy

Here’s the image of the reversal we looked at previously on the 1 hour chart of USD/JPY, remember how I said I would explain why the market has a low chance of reversing at the 23.4% level ?

The reason why It comes back to the 61.8% level before reversing rather than the 23.4% level is down to the psychology of the retail traders who have been watching the market move up before the large drop occurred.

The large move up prior to the downmove which we have drawn our retracement from, contained many traders on the 1 hour chart and below placing buy trades as they identify the move as an uptrend, when the market makes a sharp move lower a large number of these traders end up closing their long trades.

When the market begins moving back up after the fall a significant portion of these traders will believe the fall was just a pullback in the up-move, as they see the market moving higher again they will place buy trades under the impression the market is going to make a new high and the up-move is going to continue.

The bank traders who sold creating the initial down-move want to get more sell trades placed into the market, the only way for them to do this is if they have people buying. Their first sell trades consumed all the buy orders coming into the market from the traders who were buying on the preceding up-move which is why the market fell, now they have additional orders coming into the market from the retail traders buying as they believe the drop is just a pullback and the market is getting ready to break higher.

Why the market turned at the 61% fib instead of the 23.6% fib is because a large number of retail traders still believed the market could move higher, if they believe the market has further to go they will keep placing buy trades, which is why the pullback is deep as opposed to being shallow in the case of if the market was to turn at the 23,6% fib level.

In all trend reversal scenarios the market will only turn at the 23.6% fib or the 38.2% fib if the move which created the reversal is big enough to make the majority of traders active in the trend close their trades out of shock of their positions turning from negative to positive.

You can see this occur at the beginning of the EUR/USD downtrend……

image of the beggining of the eur/usd downtrend

The huge move down at the start of this downtrend shocked most long traders into closing their trades, the downmove was too big for a deep pullback to take place because the long traders didn’t believe the market had any chance of continuing to move higher.

If they did believe the market could still potentially move higher they would place buy trades and we would see the market come back to the upper fibonacci levels before reversing lower.

 

Summary

It’s important for you to understand, although most of the examples I’ve shown you over the second half of this article have been taken from big trends in the market like EUR/USD – USD/JPY the concepts described apply to trends you find on any time-frame. A deep pullback on the 1 minute chart is the same as a deep pullback on the weekly chart like we saw in the USD/JPY example, the only difference is the amount of traders who will be placing trades on the pullback movement.

This is because a deep pullback on the 1 minute chart will only be seen by traders on 1 minute chart therefore there wont be as many traders closing losing trades when the market begins moving against the deep pullback which means the movement generated by the deep pullback will not be as big.

I hope today’s article has enlightened you to some of things fibonacci retracements can reveal about the state of the market and the actions of the bank and retail traders taking part in trends and reversals, if you have any questions regarding the concepts talked about today please leave them in the comment section below.

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3 comments

  1. Garen

    Sir, even tho i understand the logic behind this observation, but i really couldn’t understand why in USD/JPY pic (one pic above of very last one) you made a retracment in a direction as if you already know that its going to be reversal ? You know what i mean ? 100% on top of the swing and 0% on the bottom of the swing! If one anticipates that this is just a retracment to up trend then logical Fibonacci will will be drawn from very beginning of this big uptrend all the way to that last high, so in that case in the point where where is the first retracment (just before the cross you labeled) will be very shallow retracment around 61.8 from point of view of retail traders. I hope i could explain what i mean and please explain to me if possible should i then expect reversal on that very top and pull the Fibonacci in a same way as you did ? (instead of assuming that this is going to be continuation of uptrend )
    Thank you in advance

    • ForexMentorOnline
      Author

      What I’m saying is the market will only return to the 61.8% fibonacci level in reversals when the traders believe a trend continuation is going to take place. This usually happens in markets that have been trending for a long time because the traders belief that the market is going to continue moving in it’s current direction is incredibly high because of the fact it has already been trending for such a long time. Of course we are not going to know for sure when a reversal is going to begin but it helps to know the level which the market will come back to if it is in fact going to reverse.

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