Why are Fib Retracements and Extensions Important
Strategic Tools . Published · By KarlVonBahnhof
Fibs, or Fibonacci retracement – the bread and butter of cryptocurrency trading when your pair keeps making ATHs. Or if it just breaks from a range. Why Fibs? Because everybody uses them. Nobody knows if they work, let alone how, but everyone uses them, which makes them self-fulfilling prophecy.
If you want to know more about Fibs in general, here is a deep dive from stockcharts. As to how they work, they basically just explain the Fib levels are based on the Fibonacci sequence, and why that particular sequence is relevant, that remains a mystery.
Not that you’d need to know to make money.
What you need to know is that Fib levels are, according to some more or less opaque theory, the price levels where the relevant price action is more likely to reverse. It can be short-term reversal, start of a corrective range or start of a bear market - Fibs don’t tell you any of this, they are just levels to pay attention to. It is also not meant to be particularly precise – it’s just levels people – nor is it meant to work out every single time – it’s just probability. No point in being too religious about it. If the action doesn’t stop on the usual fib, it just doesn’t. It’s not like the price is “due” to go back to that level. It just didn’t happen and won’t happen.
In downtrend/correction or corrective range draw the Fib by dragging from the swing high to the swing low.
In an uptrend or for DCB/bounce draw the Fib by dragging from the swing low to the swing high.
For cryptocurrency trading it seems the following fib levels are particularly important: 0.618, 1.618, 2.618, 4.236. But remember that no matter the situation, other things come into play too: do not be religious over an indicator. They are only suggestions.
It is better to be able to save your charts though, especially if you are working with longer timeframes like the daily where it might take some time before the market moves toward the next fib. For that, use TradingView like the rest of us.
Here comes the real deal.
Once more what was said earlier:
What you need to know is that Fib levels are, according to some more or less opaque theory, the price levels where the relevant price action is more likely to reverse.
This philosophy is similar to Point & Figure charting idea of long pole warning: If it goes up very fast during quite a short time, it is becoming increasingly likely that it will go down, and from experience, it should retrace to about half of the long pole (0.5 is also a Fib, by the way). You see it is all quite vague, but it is based on experience and traders trust it, so it is better not to ignore it.
Essentially the gist is that corrections of a trend are good. Once there is a correction, traders can draw a Fib retracement for that correction which then gives them the possible tops for the continuation (if other signals show that continuation is likely in the particular situation).
Image from Bitfinex. Notice also how there are several Fibs very close to each other: that’s confluence, it makes the level more important.
If there is no correction, there is no Fib retracement to draw, which makes it more difficult for the market to agree on the levels where it pauses or retraces because nobody has any idea about any guidelines to stick to. If there are guidelines – any level that attracts the attention of people looking for a number to set their limit order to – it is likely that a lot of people will happen to have orders around that level. If there is enough of these orders it will actually move the market that way. If there is no agreement though, consequently the market may start behaving irrationally for a while until a generic reason prevails and some people will start taking profits. In reaction to that the rest (the more emotional traders) will panic and capitulate. If this happens after a rally it makes for a proper dump, blood on the streets kind.
In a simplified way, if the market is trending up above all the fibs with no correction in the meantime that would create new fibs, there is not a good risk/reward ratio to buy in at that point. For hodlers: choose carefully your asset, buy when the crowd doesn’t want to and when the rally comes you will be prepared sitting on a nice stash.
About the author
Written by KarlVonBahnhof
KarlVonBahnhof also on Reddit, Chris belongs to the crypto trader class of 2013. Located in the Americas most of the time, you're most likely to meet at r/BitcoinMarkets though.