Using the Fibonacci Tool with Support and Resistance

This section further illustrates how the Fibonacci retracement and extension levels tend to have a higher probability of holding when they coincide with other types of support and resistance.

For instance, a price breakout tends to pull back to the broken support or resistance level as a retest. A downside break from a key support area, particularly in a longer-term time frame, tends to be followed by a retracement to that same level before price resumes its drop.

Similarly, an upside break from an established resistance area is usually followed by a pullback to that same level before price resumes its climb. Using the swing low to the swing high or the peak of the upside breakout should generate potential entry levels, and the one that is closest to the broken resistance area could have plenty of buy orders located.

Another way to select which Fibonacci retracement level to place an order on is the one closest to a major or minor psychological level. Since these round numbers tend to be respected best by yen pairs, this method typically works on those.

The reason why this combination of Fibonacci levels with support or resistance works as an entry method is that plenty of traders already have their eyes locked on those levels. As such, they tend to have a self-fulfilling property in that the sheer number of buy or sell orders located in those levels are enough to make it hold and trigger a bounce.

The same principle applies for selecting profit targets with Fibonacci extension levels. Potential levels could be those located at established support or resistance levels, those nearby major or minor psychological levels, or pivot points.

In the event that you are having trouble choosing among the potential Fibonacci retracement levels to set your entry order on, you might want to consider the scaling in method. This involves setting several entry orders on multiple levels, with the trade entry price being the average of those levels.

Remember that it’s not absolutely necessary to get the best possible entry price. What matters is that you did your homework, tried to come up with a high-probability setup, selected a potential entry point, and have a strategy to manage your risk properly.

Of course, nothing is set in stone in the forex market, and even the best technical analysis combining Fibonacci levels with support or resistance still has the chance of failing. This can happen when there is a sudden shift in market sentiment or an unforeseen event.

In this case, it could be a sign of a market turn and the start of a new trend. Before shifting sides, traders often zoom in to shorter-term time frames to see if there are opportunities to hop in smaller retracements.

Fibonacci retracement for intraday trading can also be used in conjunction with the previous day high, low, open, or close as these can also act as intraday inflection points.

Fibonacci Extension

As introduced in the previous section, Fibonacci extension levels serve as excellent points for setting profit targets. After all, it’s not enough that you try to pick the best entry levels for your trade. You must also be able to determine how long you plan to hold on to the trade or how long you think the market trend might last.

Just like the Fibonacci retracement levels, the extension levels are also based on the golden ratio determined by Leonardo Fibonacci. When it comes to Fibonacci extensions, the important levels to remember are 0, 0.382, 0.618, 1.000, 1.382, and 1.618.

Again, there is no need to memorize all these figures as the Fibonacci extension tool is also included among most forex trading platforms and charting software. You simply need a working knowledge of how these levels are generated and how you can apply this in coming up with trade ideas.

While the Fibonacci retracement only involves connecting two points in price action, which are the swing high and swing low, the Fibonacci extension has a third point to be connected and this is the retracement level where you plan to enter your trade or where price has already bounced. After clicking on the swing high and low, you also have to click on a specific retracement level before the extension levels automatically pop out.

As you’ve probably surmised, the Fibonacci extension levels vary depending on which retracement level you pick.

As with Fibonacci retracement levels, there is also no hard and fast rule in determining which extension level would hold best. One can make a choice depending on which level lines up with another kind of inflection point, such psychological levels or pivot points. The intersection of a trend channel with a Fibonacci extension level could also be a take-profit point.

Reversal candlesticks forming right on a Fibonacci extension level could also be a good signal to exit a trade.

Extension levels are a bit trickier to use compared to retracement levels, as price often reacts to extension levels without necessarily reversing the trend afterwards. Price could retreat upon testing an extension level but resume the overall trend later on.

More cautious traders tend to set their profit targets at the 1.000 Fibonacci extension, which is basically the latest high or low in price action. Others favor the extension level that is equal to the retracement level. For many traders, setting definite trade rules like these remove the emotional or subjective component in coming up with trade ideas.

Despite that, the use of Fibonacci extension is common among technical traders, particularly those who also watch Elliott Wave patterns or harmonic price patterns.

Fibonacci Retracement

Fibonacci retracement levels, which are commonly used to specify potential entry levels during a trending market environment, comprise another group of inflection points. These retracement levels were based the work of Leonardo Fibonacci, who is a famous mathematician known for his discovery of the golden ratio.

According to Fibonacci, this ratio describes the natural proportion of various things, from the spirals of a seashell to the high-probability forex trend retracements. When it comes to trading, the important Fibonacci retracement levels to note are the 0.236, 0.382, 0.500, and 0.618 ratios.

There is no need to memorize these figures as most forex trading platforms or charting software already include the Fibonacci retracement tool. All you need to do is to connect the latest swing low to swing high in an uptrend or the latest swing high to swing low in a downtrend, and the Fibonacci retracement levels will automatically be generated.

What’s important to note when using this tool is how to connect the proper swing highs and lows. A good rule of thumb to determine a swing high is to look at the highest point of the trend with the previous two candles closing below it and the next two candles also closing below it. For the swing low, this is the lowest point of the trend with the previous two candles closing above it and the next two candles also closing above it.

Another rule of thumb is to go from left to right. In an uptrend, you should be going from the swing low to the swing high in later price action. For a downtrend, you should be connecting the swing high to the swing low in later price action.

Now, once the Fibonacci retracement levels are generated, how do you decide where to set your entry orders? One way to go about it would be to pick the level that lines up with the most inflection points, such as the pivot points or psychological levels.

Another way would be to select the level that coincides with a prevailing trend line. Other traders pick their entry point when reversal candlesticks have formed and they decide to enter their trades at market.

There is no hard and fast rule to pinpoint exactly which Fibonacci level is most likely to hold as support or resistance. A good grasp of market psychology, fundamentals, and other technical factors could guide you in your technical analysis, but this kind of understanding is developed with enough practice and screen time.

As for setting profit levels, another kind of Fibonacci levels comes in handy. These are known as Fibonacci extensions and are covered in the next section.

Different Types of Inflection Points

There are several types of horizontal inflection points that can be employed in forex technical analysis. Among these, the most common ones are the psychological round numbers, which tend to hold well as support or resistance for major currency pairs and yen pairs.

Major psychological levels refer to price levels ending in 00, such as 1.3400 for EUR/USD or 95.00 for USD/JPY. Generally speaking, the more zeroes at the end of the price level tends to result in a stronger inflection point. For instance, 100.00 holds as a strong support or resistance level for USD/JPY while parity or 1.0000 tends to elicit a bounce from AUD/USD or USD/CAD.

Minor psychological levels are those that end in 50, such as 1.6550 for GBP/USD or 171.50 for GBP/JPY. These tend to hold as intraday support or resistance, particularly when they line up with other kinds of inflection points and create what traders typically call a confluence.

Other kinds of intraday inflection points include the previous day high, low, open and close. The previous day high is usually treated as a resistance level for potential rallies, with an upside break acting as a signal that further gains are in the cards. The previous day low is usually considered a support level for potential price declines, with a downside break acting as a signal that further losses might take place.

Average true ranges are also used in determining intraday inflection points, particularly among day traders or scalpers. The top and bottom daily average true range or ATR is calculated based on the average price movement per day for a specified number of days to be set by the trader. These usually act as support and resistance for the day, where price is expected to turn. A break above or below these levels could be indicative of stronger rallies or selloffs.

As mentioned in the previous section, technical indicators such as moving averages can also be treated as support and resistance. In particular, the 200 SMA or simple moving average on the daily time frame is usually considered support or resistance, depending on how the trend is going. During an uptrend, price is expected to bounce off the 200 SMA while a market downtrend could see the price bounce below the 200 SMA.

Bollinger bands can also serve as dynamic inflection points, with the upper band serving as resistance and the lower band acting as support. Just as with other types of inflection points, a break above the resistance could be a signal for more gains while a break below the support could indicate further losses.

Trend lines, uptrend and downtrend channels, as well as pivot points can also serve as support and resistance. These inflection points are determined mostly based on past price action, with trend lines and channels created by connecting the recent highs and/or lows of price action and pivot points calculated using formulas incorporating the open, high, low, and close for the previous period. Details for these kinds of inflection points are covered in the next sections.

Pivot Point Calculation Methods

Pivot point calculation can be tedious for some but there are traders that find this method very reliable when coming up with shorter-term trade setups. Trading the news or economic events can also be combined with intraday setups using pivot points.

In particular, range traders look at pivot points for potential reversals in price action. Trend traders watch breakouts from pivot points to see if further gains or losses are about to take place.

Pivot point formulas generate support and resistance levels, along with the pivot point for the day. The basic formula derives the pivot point by getting the average of the previous high, low, and close.

From there, the first support level is calculated by multiplying the pivot point by two then subtracting the previous high. The first resistance level is calculated by multiplying the pivot point by two then subtracting the previous low.

The second support level is calculated by adding the pivot point to the difference of the previous high and low. The second resistance level is calculated by subtracting the difference of the previous high and low from the pivot point.

Charting software and most trading platforms usually have these pivot point calculators or tools that can automatically generate these inflection points so there is no need to memorize the formulas. However, it’s important to have an idea of how these levels are generated in order to better take advantage of the potential trading methods using these tools.

Other pivot point calculation methods exist and might be more effective means of determining inflection points, depending on your trading method. For instance, there’s the Woodie pivot point method which generates very different support and resistance levels from the basic one.

Another kind of pivot point calculation is the Camarilla equation, which can generate as much as four support and resistance levels. Fibonacci pivot point methods are also an option, possibly when a trader is looking to combine these levels with Fibonacci retracement or extension points during a market trend.

There is no saying which among these methods is the best one, as it varies depending on market conditions or how these inflection points are incorporated in one’s trading strategy. What is important is that the trader has a clear understanding of how the support and resistance levels are generated in order to figure out if it is an appropriate trading method.

The simplicity and objectivity of pivot points makes it one of the most watched levels among forex traders, giving the inflection points a self-fulfilling trait. Buy or sell orders could be located around pivot points, especially when these line up with major or minor psychological levels.

In addition, the flexibility of using pivot points as levels to watch for range and trend traders makes it more appealing to use. The convenience of having pivot point calculators also makes for an easy-to-use trading method.

Trend Lines and Channels

Forex traders often say that “The trend is your friend” because a market uptrend or downtrend provides several reliable opportunities to catch pips. During these kinds of market behavior, trend lines and channels can be the most reliable technical analysis tools.

Trend lines are drawn simply by connecting the recent highs or lows of price action. To be specific, an uptrend line or ascending trend line is drawn by connecting the latest lows with a straight line. A downtrend line or descending trend line is created by connecting the latest highs with a straight line.

An ascending trend line tends to act as support for price action if the uptrend continues. Price often pulls back to the rising support level and bounces if buying momentum remains strong. The creation of new highs indicates that the uptrend will carry on.

On the other hand, a descending trend line is treated as resistance for price action if the downtrend is strong. Price often pulls back to the falling resistance level and bounces if selling momentum carries on. The formation of new lows suggests that the selloff is likely to continue.

As with other types of inflection points, a break above the falling trend line resistance indicates that the downtrend may be over and that a reversal could take place. Conversely, a break below a rising trend line support suggests that the uptrend is about to turn.

Channels are simply trend lines drawn parallel to one another. In particular, an ascending channel is formed when the rising trend line connecting the lows of recent price action has a parallel rising trend line connecting the latest highs. A descending trend channel is created by drawing a trend line connecting the latest highs and having a parallel downtrend line connecting the latest lows.

Channels tend to be more potent trade signals since these could also provide potential take-profit levels. Trend-following traders could enter trades in the same direction of the overall market trend, which means shorting at the top of the falling channel or going long at the bottom of a rising channel. Countertrend traders could enter trades in the opposite direction of the channel trend, which means going long at the bottom of a falling channel or shorting at the top of a rising channel.

Of course, countertrend trades tend to be a little more risky while trend-following setups do have a higher probability of winning. Traders often look for confluence or the lining up of several kinds of inflection points for confirmation before deciding to jump in a countertrend setup.

Support and Resistance

Support and resistance are two of the most frequent forex terms you will come across in technical analysis. Simply put, support refers to a floor in price action where a downward movement changes course. On the other hand, resistance stands for a ceiling in price action where an upward movement reverses.

A good rule of thumb for identifying support and resistance levels is waiting for a couple of tests or bounces, which indicate that the levels are holding. However, as the number of bounces off those levels increase, so does the probability of breaking in the next tests.

When support or resistance levels do break, they tend to flip roles especially when there is trending market behavior. In particular, when a support level breaks during a downtrend, it could act as resistance for future price action. When a resistance level is broken during an uptrend, it may act as support for later movements.

What you should be careful of though is fakeouts or false breakouts. There may be instances when it appears that price action is already making a break above resistance or below support, but you should look at the close of longer-term candlesticks to determine whether those inflection points have been broken or not.

Another thing to remember is that support and resistance are not always horizontal levels, although those are the most basic and commonly seen inflection points. Support and resistance can come in the form of trend lines or channels, which are diagonal lines connecting recent price highs or lows. Moving averages or other technical indicators may also act as dynamic support and resistance levels.

There are other technical tools that can be employed to calculate potential support and resistance levels, even if these floors and ceilings haven’t been established by past price action. For intraday traders, pivot points are typically calculated using various formulas to identify potential barriers for price action for that particular trading day.

In addition, Fibonacci retracement and extension tools can be used to pinpoint potential support and resistance as the market trend progresses. When these line up with horizontal levels or other possible inflection points, they tend to act as stronger floors or ceilings for price movement.

These types of support and resistance levels are covered in the next section, which details how various inflection points can be combined to generate better trade setups for predicting market turns.

Group Candlestick Patterns

Group candlestick patterns are more creative but take time to form. Generally, these are believed to be more effective signals when they occur on the longer-term time frames.

First is the three-inside-up or three-inside-down pattern, which is basically indicative of a possible reversal. It can be considered a harami double candlestick pattern plus an additional confirmation candle.

The first candle is a long one in the direction of the previous trend, with the second candle as an inside day pattern. The third or confirmation candle is another long one in the direction of the reversal trend, closing higher than the first candle for a bullish signal or lower than the first candle for a bearish signal.

Next is the three-outside-up or three-outside-down pattern, which basically looks just as it sounds. This can also be considered an engulfing double candlestick pattern with an additional confirmation candle.

The difference is that the first candle is a short one in the opposite direction of the previous trend. The second candle should engulf the first one and should be in the direction of the reversal. The third or confirmation candle should also be in the direction of the new trend and must close higher than the second candle for a bullish signal or close lower than the second candle for a bearish signal.

Another interesting and reliable triple candlestick formation is the three white soldiers. This is a bullish signal simply comprised of three long white or green candles, hinting at further gains for the forex pair.

The bearish counterpart of the three white soldiers is the three black crows. This is comprised of three long black or red candlesticks, indicating that a deeper selloff is in the cards for the pair.

The morning star, which is a bullish signal, occurs at the end of a downtrend and signals the start of an uptrend. The first candle is a bearish one while the second candle gaps down for the open but closes higher. The third candle is a bullish one, covering most of the first candle’s body.

The second candle could also be a doji, which would make the pattern a bullish doji star formation.

The evening star, which is the bearish counterpart of the morning star, occurs at the end of an uptrend and signals a potential downtrend. The first candle is a bullish one while the second candle gaps higher for the open then closes lower. The third candle is a bearish one, covering most of the first candle’s body.

As with the morning star formation, the second candle can also be a doji, making tis a bearish doji star pattern.

A triple candlestick pattern similar to the morning and evening star patterns is the abandoned baby. This is also suggestive of a price reversal.

A bullish abandoned baby pattern has a first candle that is bearish, followed by a gap down and a doji for the next candle. This is then succeeded by a bullish candle gapping higher and closing inside the first candle.

Conversely, a bearish abandoned baby pattern has a first candle that is bullish, followed by a gap higher and a doji for the second candle. This is then followed by a bearish candle gapping lower and closing inside the first candle.

Double Candlestick Patterns

Memorizing double candlestick patterns can be a bit more challenging, but the trading results can be very rewarding. As with the single Japanese candlestick patterns, these come in bullish and bearish versions.

The most basic type of dual candlestick formation is the bullish or bearish engulfing pattern. Simply put, the engulfing pattern occurs at the end of a market trend, with the first or setup candle showing signs of exhaustion and the confirmation candle indicating a complete takeover or reversal.

In other words, the confirmation or second candle’s high is higher than that of the setup candle and its low is lower as well. Another kind of dual candlestick formation is the harami. In Japanese, this translates to “pregnant”, which is an easy way of remembering how the pattern looks like. It can be considered a reverse of the engulfing pattern, as the confirmation candle has a lower high and a higher low compared to the first candle.

This pattern is also known as an inside day formation. A variation of this pattern is known as the harami cross, wherein the second candle is a doji that is inside the first candle. This also has a bullish and bearish version, both of which indicate a potential price reversal.

Next up are the tweezer tops and bottoms. This kind of double candlestick pattern also occurs on top of an uptrend or at the bottom of a downtrend, signaling a possible price reversal. The name of the formation is given because of the double highs of tweezer tops or double lows of tweezer bottoms which should be of equal length.

Furthermore, the first candle of the tweezer top or bottom should be in the direction of the previous trend. In other words, a tweezer top should have a bullish first candle while a tweezer bottom should have a bearish first candle. Then the second candle should be the opposite of the previous trend, which means that a tweezer top should have a bearish second candle while a tweezer bottom should have a bullish second candle.

One of the more rare double candlestick patterns are the hammer and inverted hammer, both of which also hint at possible reversals. The hammer has a small body with a long lower wick and no upper wick while the inverted hammer has a small body with a long upper wick and no lower wick.

The bearish hammer is also known as a hanging man while the bearish inverted hammer can also be called a shooting star. For these dual candlestick patterns, the first or signal candlestick is a long candle followed by a gap down before the second or setup candle.

Common Candlestick Formations

Single candlestick patterns are perhaps one of the most straightforward ways of reading price action and interpreting market psychology. Candlesticks with long bodies and short wicks signify strong buying or selling momentum that is likely to carry on until a reversal candlestick is formed. Meanwhile, candlesticks with long wicks and short bodies can either reflect indecision or a battle between buyers and sellers. The most well-known single long candlestick pattern is the marubozu, which means bald in Japanese. Strictly speaking, a marubozu is either a long green or red candle with no wick at all. However, a long candlestick with very small upper or lower wicks can still fall under this category. A bullish marubozu is a long green or white candle, which has an open price equal to the low of the period and a close price equal to the high of the period. A bearish marubozu is a long red or black candle, with the open price equal to the high of the period and a close price equal to the low.

When a bullish marubozu is formed on a daily chart, this means that buying has occurred throughout the day and is likely to carry on the next day. Conversely, a bearish marubozu on a daily chart indicates that sellers were in control of price action the entire trading day and are likely to push the pair lower for the next day. Another common single candlestick pattern is the doji. This is easily recognized as a candle with long upper and/or lower wicks with practically no body. In Japanese, doji translates to a mistake, which means that plenty of action took place during the period but that price eventually closed right where it opened. There are several varieties of doji candlesticks and these are usually associated with reversals. For instance, a dragonfly doji, which is formed when the open, high, low and close of price action for the period are all equal, acts as a bullish signal when it forms at the bottom of a downtrend. A gravestone doji, on the other hand, is formed when the open, close, and low for the period are all equal and it can serve as a bearish signal when it occurs at the top of an uptrend.

In addition to the dragonfly and gravestone dojis, the long-legged doji can also be used to signify potential market reversal. However, this usually requires confirmation from the next candlestick. Spinning tops are also treated as signals for price action reversal, although their reliability is said to be lower compared to that of doji candlesticks. Spinning tops have a small body with long wicks on both ends.