The idea of having a formula that will magically predict the end of a correction period (Fibonacci retracements) sounds awesome.
Sounds like a tool everyone would like to use (including myself)…
But, does it really work?
That’s exactly what we are going to discover in this article, so please, fasten your seat belt.
Basically, Fibonacci retracements are used to identify the end of a correction period. Traders use these levels to find possible entries, specially when the market is trending up or down.
For instance, lets say that the market is trending up, after a major swing, the market will retrace back to either: 38.2%, 50%* or 61.8% (according to the Fibonacci Retracements, these are the most common retracement levels).
*50% is not a number found in the Fibonacci sequence, it comes from the Dow Theory, but most charting packages use it as a Fibo level, so we’ll consider it as a retracement level.
After a mayor advance, the market is expected to correct a portion of the prior advance, which according to Fibonacci retracements, could be 38.2%, 50% or 61.8% form the previous advance.
Sounds good right?
Lets look at some charts…
This is the EURNZD 1D Chart:
To get the retracement levels, you need to select your Fibonacci retracement tool on your charting package, draw a line from top to bottom and you’ll get the retracement levels automatically.
In this case, looks like the correction ended at the 38.2% retracement level. In theory, it is likely to resume its uptrend.
Here is another example:
AUDUSD 4H chart:
In this case, the AUDUSD bounced back to the 61.8% retracement level…
It makes sense correct?
The Case Against Fibonacci Retracements
In theory this is awesome, having a magical formula that somehow knows exactly at what level the market will retrace to is just perfect.
A very handy tool that could help us getter results… yeah right!
Trader, if you’ve never use it, please save yourself some money and time and forget about it!
If you are currently using it, think about it for a moment…
Does it really make sense? That this magical formula knows exactly at what level the market will retrace back to every single time?
It just doesn’t my friend, it doesn’t make sense. There is no magic.
Let me ask you one question, would you rely on something that you don’t understand? Of course you know what the formula is and everything, but do you know the “why’s”?
Why is it that the market needs to retrace back to these levels?
Let say you are a full-time trader, and you need to pay the rent or mortgage, your child’s school and utilities… would you rely on something you don’t understand?
I know I wouldn’t. If I need to pay the rent, etc I need to feel confident about the way I’m trading, and in order to feel confident about it you need to know your strategy inside out, you need to understand the market you are trading, the system you are using, etc.
But again, if you ask me if I would I like to have a tool like that? Of course I would… but it just doesn’t exist.
You never know when a correction is over until it has already happened!
Fibonacci retracements on hindsight are very simple to determine. But try it on the right hand side of the chart… Very difficult ha?
Its exactly the same feeling you get when using a MA crossover, when you look at them on hindsight its very simple, but try it live and you end up with frustrated and with an empty account.
Relying solely on Fibonacci levels is suicidal.
Why is it that Fibonacci Retracements are used by a ton of traders?
Before I continue, let me tell you that at one point in my career as a trader I used it, I even used other related tools and types of analysis like Elliot Waves, and others.
Ok, now to the answer… I think there are two possible reasons:
1 – Its humane nature to try to find a “reason” for everything.
That’s the reason there are thousands of technical indicators… traders are always trying to figure out what “made” the market behave like that…
So it would be like this: Ahhh now I know why I got stopped out… I took my trade at the 38% retracement, and the market actually retraced back to the 62% retracement level…
You see what I mean?
And the second reason…
2 – Now you can blame something else…
If you are like most traders, we don’t like to take responsibility of losing trades. So if the market didnt behave as expected… you would go like: Ahhh this Fibonacci thing didnt work…
Do you agree with me?
How you need to trade
I think that the best way to trade, is to understand what the market is doing. Once you have a complete understanding of what the market is doing, you adapt your system, and trade accordingly.
That simple, if the market is ranging, look for trade opportunities on both extremes of the range.
If its trending up, look for longs, if the market is trending down, look for shorts.
If you have no idea of what the market is doing, don’t trade it, and find another instrument that is clearer.
It is very important not to focus in one oro two instruments. Everyday you need to find the instruments that have the clearest market conditions, and focus on them!
What about Elliot Waves and other types of analysis that rely on Fibonacci?
Forget about them! They are even worse, but that’s another story, we’ll talk about that later.
Do you use Fibonacci?
What do you think about it?
Do you agree with me?