Where exactly is that? For starters, we need to identify an extended move up or down on our chart. In other words, a swing low followed by a defined high or a swing high followed by a defined low. Below, we have an example of a swing high (labeled 1) followed by a swing low (labeled 2).
Drawing Fibonacci Retracement on a Chart
What Do the Fibonacci Lines Mean?
After drawing the two data points, we see 3 blue lines appear between the high and the low: 0.382, 0.500, and 0.618. These numbers represent how far price could retrace in percentage terms. So if price rose back to the 0.382 level, that would be a retracement of 38.2% of the original move. If price rose to the 0.500 level, that would be a retracement of 50% of the original move. If price rose to the 0.618 level, that would be a retracement of 61.8% of the original move.
We can see these levels labeled in the chart below as potential resistance levels. These are price levels that price could bounce off of.
Fibonacci Retracement Projecting Potential Resistance Levels
There is no exact science to determine which level price will bounce or
if price will bounce off any of the levels at all. But time and time
again, we will see price bounce off of one of these three retracement
levels created by using Fibonacci.
Why Does Fibonacci Seem to Work?
This is probably the most popular question I get regarding Fibonacci. Why does price bounce off these levels? What is the ‘magic’ that causes this? In my opinion, there is no magic involved in it at all. What causes price to sometimes react around these levels is due to the fact that many people are watching these exact same levels.
If we have a large number of traders all looking at the same levels for a turnaround in price, they could create a cluster of orders that causes price to actually turn around at that level. It won’t always be that cut and dry, but that is the gist of using this type of tool. We are expecting other traders to be looking at these levels and cause price to react at these levels. It is self-fulfilling,
Price Bouncing Off Fibonacci’s 38.2% Retracement Level
The chart above shows the outcome of our example. Price retraced up to the 38.2% retracement level and stalled for a while before moving back in the direction of the original move. Traders that traded the potential bounce off of this level had a very successful trade without having to take on a lot of risk if they used a tight stop.