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How to Use Fibonacci Retracement to Spot Market Tops and Bottoms

fibonacci_retracement

Last Updated October 25, 2016

You’re probably familiar with Fibonacci retracement. Whether you use it as a compliment to another strategy or to confirm key levels, chances are you’ve worked with it in some manner.

However, I can all but guarantee that you haven’t used it in the way I’m about to show you.

The very notion that the Fibonacci retracement tool can help us identify support or resistance lends itself to another huge advantage that’s as powerful as it is obscure.

What is it, you ask?

It’s a way of identifying major market tops and bottoms. If that sounds too good to be true, I can assure you that it isn’t. And while no method is foolproof, this one has allowed me to make some of the biggest profits of my life over the last couple of years.

By the time you finish this lesson, you’ll understand Fibonacci levels inside and out and be able to use what we know about how they work to confirm potential market tops and bottoms.

As always, be sure to leave a comment at the end of this post and let me know what you think.

Let’s begin.

What is Fibonacci?

The more appropriate question is “who” is Fibonacci?

Leonardo Bonacci – better known as Fibonacci – was an Italian mathematician born around 1170 (contrary to popular belief the exact date is unknown).

He was considered to be the most talented mathematician of the Middle Ages, and for a good reason.

Not only did he develop the Fibonacci sequence, which all Forex traders are familiar with, he also popularized the Hindu – Arabic numeral system in the Western World.

His research on the Fibonacci sequence of numbers is considered to be his crowning achievement. It’s also the most widespread in its use, as you’ll discover shortly.

Like the uncertainty about when exactly Leonardo Fibonacci was born, the same ambiguity surrounds his death, which is estimated to be between 1240 and 1250.

How Does Fibonacci Work?

I would argue that understanding how the Fibonacci sequence works is the most overlooked aspect of trading.

After all, most trading platforms give us a Fibonacci retracement tool that has all of the math built-in, so all we have to do is click and drag.

But taking the time to understand the depth and power behind this type of analysis are what will set you apart as a Forex trader. Any time spent adding meaning to a concept you use on a weekly basis is time well spent in my opinion.

Okay, so to get things started, I have a question for you…

What do a plant and a snail shell have in common with the charts we use to trade the Forex market?

You got it – they all have Fibonacci attributes.

Yes, the profit you just made from selling the EURUSD rally at the 61.8% Fibonacci retracement level can, in many ways, be attributed to the study of plants, flowers, and even snail shells.

The same levels you use on your charts were first studied in nature. After all, Mr. Fibonacci was by no means a trader in his day.

I should note, however, that not all charts play by the rules. You’ll find that some currency pairs respect these levels more than others.

But all in all, it can be a great asset if properly used.

The premise of Mr. Bonacci’s study was to identify a numerical order, or explanation, to a seemingly random world. In the case of many plants, it’s thought that a Fibonacci sequence exists to maximize space and efficiency.

In the trading world, this same sequence (except for the 50% level which is not in the Fibonacci order) helps to explain human behavior. After all, everything you do as technical traders is contingent on a particular pattern of human tendencies.

So just like the plants and snail shells, there is a “method to the madness,” if you will, that helps to explain why certain patterns exist, both in nature and on the charts we use.

Using What We Know to Spot Turning Points

Okay, at this point you know who Mr. Bonacci (better known as Fibonacci) was, and you should also understand the significance of the sequence of these numbers to some degree.

If not, be sure to review the links above before moving on.

To sum up, the retracement tool is most often used to identify support or resistance during a pullback in a trend.

However, there is a less obvious way to use this to our advantage. Dare I say that what I’m about to show you is even more beneficial than the conventional way of using Fibonacci levels.

You see, most traders use the tool within a limited scope. They plot the levels on a 1-hour or 4-hour chart which spans a few days or possibly a few weeks.

Additionally, these same traders only use the tool once the market has turned over or directly within a trending market.

If you’re using the Fibonacci tool only in this manner, you’re missing out big time!

Here’s why…

Let’s say you plot the tool on the NZDUSD daily chart during an uptrend and find confluence at a few levels you had previously identified. Remember that we don’t use the Fibonacci tool to find key levels, only to verify them.

So before you’ve drawn any retracement levels your chart looks something like this:

nzdusd-support-levels

Notice we have a few critical horizontal support levels within an uptrend.

I think we can all agree that the three areas above are certainly worth keeping an eye on.

If we then use our Fibonacci retracement tool and drag from the major swing low to the recent swing high we get the following:

nzdusd-fibonacci-levels

Notice how the three levels we identified previously line up with the 61.8%, 50%, and 38.2% numbers.

This is a great start to any analysis, but here’s where a lot of traders miss out.

They see the NZDUSD as a potential buying opportunity at one of the levels of confluence above. After all, the market is in an uptrend, right?

While that may work for a short while, here’s what I see:

nzdusd-market-top

Note that we have an ascending channel (a possible bear flag pattern in the making) where the Fibonacci levels from bottom to top line up with previously defined support areas.

So instead of seeing potential areas at which to buy, I see a potential (major) market top forming.

How did I come to that conclusion?

Because if the market rallies any higher than the current high you see in the chart above, those Fibonacci levels won’t line up with our support levels.

In essence, we’re utilizing the “big picture” in combination with what we know about the Fibonacci tool to spot major turning points.

It isn’t a perfect science, but it has worked well for me in the past. More on this shortly.

Always remember that all technical analysis is only as valid as the context in which it occurs. What may seem like buying opportunities could very well be a sign of exhaustion amidst a multi-year downtrend.

A Few Market Tops Using This Method

Now comes the really fun part – the case studies.

Before we begin, I’d like to say that the following examples occurred in real-time. It’s not hindsight nor is it some backtesting methodology that discriminates against false positives.

Also, by their very definition, major market tops, and bottoms – those that often represent multi-year highs and lows – don’t come around often. In fact, every case study below took several years to develop fully.

But make no mistake, the potential reward is well worth the wait.

First up is the GBPJPY. The following two charts are the same ones I posted over a year ago on September 9, 2015.

fibonacci-retracement-tool

The GBPJPY weekly chart above illustrates the method’s simplicity. I merely dragged the Fibonacci tool from the major swing low in 2011 to a recent high (at the time) in mid-2015.

Now, at this point you may be thinking, so what?

But if you take the time to understand how Fibonacci works – which you should have at this point – the chart above is extremely telling.

Let’s take a closer look at what’s happening here.

gbpjpy-fibonacci-levels

Notice how each level of the Fibonacci sequence lines up with a prominent swing high or low. At the time it was an excellent indication that the GBPJPY had topped out and was likely in for tough times.

Remember, if the high in 2015 hadn’t lined up where it did, the three levels in the chart above wouldn’t match up with these noticeable areas.

Fast forward to today and the pair is off of those highs by an impressive 5,700 pips.

Here’s a current chart:

GBPJPY weekly chart

You can read the full commentary from 2015 at the link below.

Major Top in Place for GBPJPY?

If you aren’t convinced just yet that’s okay; I’ve got one more example.

Next is a monthly chart of NZDJPY. This analysis was something that I posted inside of the member’s area on February 26, 2015.

nzdjpy-monthly-chart-with-fibs

Notice how, once again, the 38.2% and 50% levels line up perfectly with critical horizontal areas (the ones in red) that I had previously drawn.

This occurrence was not a mere coincidence. It was a red flag that the risk-sensitive pair had just carved out a major top.

In fact, here is the very post where I mentioned the idea that the NZDJPY had put in a major top in 2014.

NZDJPY monthly chart with Fibs

And here’s how the pair looks today:

nzdjpy-monthly-downtrend

While the move above may not seem so drastic, keep in mind that we’re viewing the monthly time frame. So the shaded area above totaled a not-so-insignificant 1,600 pips.

So how did I know the pair had carved out a multi-year high?

To be clear, nobody knows what will happen next in any market, and I’m no exception.

However, the fact that these two levels lined up so perfectly with prominent swing highs and lows was a monumental hint that a major reversal was in the cards.

And although it wasn’t a direct product, the Fibonacci analysis above gave me the confidence needed to call a 1,500 pip drop in NZDJPY on May 6, 2015.

So now you can see how this type of “big picture” analysis can be hugely beneficial to your trading performance.

A Multi-Year Top in the Works?

Now that we’ve discussed how a simple Fibonacci analysis can help us identify potential turning points in the market let’s take a look at something that is happening as I type this lesson.

Everyone knows that the equity markets have been in rally mode for years, most since 2009. And despite what some media outlets may say or think, all good things do eventually come to an end.

Whether it has in fact been a “good” thing is very relative.

But this isn’t just another market prediction. In fact, I don’t like to think of it as a prediction but rather a troubling sign that the August 2016 highs may be the last for quite some time.

Take a look at the Dow Jones monthly chart below:

dow-jones-fibonacci-analysis

Note: The all-time low of 28 occurred on August 8, 1896, so I wasn’t able to capture this level in the chart above.

Notice how the Fibonacci levels on the monthly time frame of the Dow Jones Industrial Average above line up with major swing highs and lows.

I don’t know about you, but this chart gave me chills when I first drew these levels. And knowing what you do now about what this could mean (think of the GBPJPY and NZDJPY scenarios we just covered) should kick up the fear factor a little more.

So what does this have to do with the Forex market?

Everything!

No market operates in a vacuum. What happens with equities, bonds, etc. can and does affect currencies and vice versa. Look no further than the 2008 global crisis era for some chilling examples.

I could be completely wrong here and for the sake of the world economy, I hope I am. But the chart above offers the same bearish signs as the GBPJPY and NZDJPY charts before it.

Whether or not it plays out in a similar manner is yet to be seen, but the warning signs are there.

Avoiding False Positives

The very best way to avoid false positives – anything that incorrectly indicates the potential for a major top or bottom – is to use this technique on a higher time frame over an extended period.

Let’s define both of those now.

I always use the weekly or monthly chart when determining the potential for a major top or bottom in any market.

And just like the Dow Jones, GBPJPY and NZDJPY charts above, it’s best if you can gather data that spans at least three years. The greater the distance between your Fibonacci start and end points, the better.

So here they are again…

  • Higher time frame: Use the weekly or monthly charts to identify your start and end points
  • Extended period: Make sure you have a few years of data to measure, preferably at least three years

Another excellent way to avoid false positives is to confirm your measurement with more than one Forex broker.

As you may well know, volatility can sometimes adversely affect your technical analysis, including the use of the Fibonacci tool.

Take a look at the chart below. It shows a spike high for the GBPNZD among three leading Forex brokers. Note the disparity between each one and the plethora of Fibonacci levels that resulted because of it.

GBPNZD fibonacci levels on the daily chart

Not much help if you’re trying to identify what the rest of the marketing is seeing, is it?

The increase in volatility caused three very different session highs to form for the same currency pair. This, in turn, threw off our Fibonacci analysis.

To avoid this type of mishap you may want to verify the data on your chart across two or more brokers.

Remember that the Forex market is decentralized, which means there’s a greater chance of price variance among providers particularly when volatility picks up.

Last but certainly not least, the very best way to mitigate false positives is to never rely on one method or strategy.

As I mentioned at the beginning of this lesson, you should never employ a single technique such as the one we just discussed without complimentary strategies or methods.

Final Words

Using Fibonacci analysis to identify potential tops and bottoms in a market can be a great addition to any trading style.

However, always be sure to use this technique on a higher time frame and over an extended period, preferably several years worth of pricing data. Doing so will help reduce false positives.

Also, like everything we do as Forex traders, the technique above should be utilized in combination with other methods or strategies, never on its own. While it is undoubtedly a powerful technique, it’s useless if you don’t have a plan in place to take advantage of it.

There is no single best way to use the Fibonacci retracement tool. You can utilize it in the way you just learned or in something as simple as identifying favorable entry points within a trending market.

But like everything you do as a trader, the most important thing to consider is whether a particular method works for you.

Always ask yourself, does this fit my trading style and my personality? Because if it doesn’t, it will be that much harder to extract tangible benefits.

Your Turn

Do you use Fibonacci analysis in your trading? If so, how?

Leave your comment or question below, and I’ll get back to you shortly.

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