Identify support and resistance levels with Fibonacci Retracements
Summary: In extreme market conditions, having efficient tools at your fingertips that can determine reversal levels is key. In this article we explain the benefits of using Fibonacci retracements to identify your support and resistance levels, and how to apply them in SaxoTraderGO.
The golden ratio and Fibonacci
The golden ratio is not only common in trading. In fact, it occurs in nature, architecture and even in paintings. More specifically, two quantities are in golden ratio if their ratio equals the ratio of their sum to the larger of the two quantities. Or mathematically expressed, (a + b)/a = a/b = 0.618.
As an investor or trader, you´re probably more familiar with Fibonacci. What you may not know is that the Fibonacci number string stems from the golden ratio. Mathematically, the number string goes: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55.. with the string continuing on indefinitely.
The Fibonacci retracement levels are horizontal lines on a chart that indicate support and resistance levels. These levels are all derived from the ratios found in the Fibonacci number string. If you divide one number in the sequence by the next (aside from the first few numbers), the answer tends towards 0.618 – the golden ratio. And if you divide by the second and the third number to the right in the sequence, you get 0.382 and 0.236. The full range of Fibonacci retracement levels include 0.786, 0.618, 0.5, 0.382 and 0.236. The Fibonacci retracement indicator is useful because it can be drawn between any two significant price points, such as a high and a low, and the indicator will create the retracement levels between those two points.
Why Fibonacci retracements are efficient market indicators
The golden ratio can be spotted in multiple contexts, but why is that? The simple answer is that it ‘looks right’. Purposely or not, buildings throughout history, including the pyramids of Egypt, have been built based on the ratio because it´s pleasing to the eye.
With many traders looking at the same charts and trying to determine entry and exit levels that ‘look right’, natural support and resistance levels emerge that lead us back to the golden ratio. This in turn supports the efficiency of applying Fibonacci retracements to your analysis.
Identifying support and resistance levels using Fibonacci retracements
In SaxoTraderGO, it´s easy to plot the Fibonacci retracement levels. First, you identify whether your instrument of interest is in an upward or downward trend. In the graph below we´re using the US500 as an example. It has a previous market high of 3,397 points and a bottom of 2,184 points, meaning it’s in a downward trend. Next, select ‘Fibonacci retracements’ under ‘Annotations’ and place the 0.000-line at the bottom and the 1.000-line at the previous high (reverse order in an upward trend).
By using the different retracement lines, you can identify support and resistance levels. In the US500 example, the price moved between support at 0.236 and resistance at 0.382 for eight consecutive trading days, before breaking up through the resistance level at 2,647 points. The breakout through the resistance level suggests a continuous upward movement, which was the case in this example. Note that it´s important to use additional indicators to identify breakouts, such as confirmed candlesticks above the retracement line, as retracement levels shouldn´t be relied on exclusively.