Using Fibonacci retracements to locate support and resistance levels

Beyond the most common trading techniques, Fibonacci retracements have multiple uses. One often overlooked strategy allows traders to locate future support and resistance levels for short-term trades on daily charts.

Below is the daily chart for the pound sterling versus the Japanese yen, currency pair GBP/JPY:

GBP/JPY dropped sharply during the last months of 2008 in response to the global financial crisis. It bottomed out at 118.79 on 23 January 2009, and quickly retraced to the 163.00 level in June and August of that year, forming a nice double top with a neckline around 148.00.

Drawing a Fibonacci retracement from the low to the double top formation gives the following chart, enlarged to show detail:

It’s instantly clear that the various Fibonacci retracements were respected as support levels on the price’s track down. The neckline of the double top coincides with the 38.2% retracement level, but all Fibonacci levels have had their say regarding the price action, including the 76.4% level, which is often forgotten amongst its more widely recognised brethren.

(The major Fibonacci retracement levels are 38.2% and 61.8%, but 23.6% and 76.4% should not be ignored. Note that 50%, while not truly a Fibonacci number, is widely included and used by traders due to the influence of the Elliott wave practitioners.)

According to general Fibonacci trading theory, the retracement should have hit one of the significant levels, then turned and powered higher, past the 0% line to an extension level such as 161.8% or 261.8%. Why instead did these levels serve as support and resistance?

After a retracement begins, many technical forex traders use the Fibonacci drawing tool within their online trading platforms to mark the various retracement levels. These traders then trade those levels, opening long or short orders at the various Fibonacci percentages, with stop loss or take profit orders positioned at other levels. However, these Fibonacci trades can be influenced by other positions within the forex trading market, and even annulled by them.

For example, clearly the number of forex traders who expected the 50% level to mark the deepest retracement was sufficient to overwhelm the traders who were shorting the double top. So many buy orders were entered at roughly 141.00, it took two weeks of trading (in the centre of the chart) before some of the double top short sellers surrendered and closed their positions. The resulting influx of buy orders (the short covering plus the Fibonacci traders) shot the price higher, straight back to the base of the double top.

The forex trading market continues to seek the appropriate level for GBP/JPY. Safe-haven yen bulls still dominate, and the Fibonacci retracement has been pushed down to range-trade between 76.4% and 61.8%. A 100% retracement is not out of the question, and the Fib traders’ extension may never occur. But for those traders who recognise the value of the support-resistance levels the Fib traders provide, the profits are there to be made.