I use Fibonacci retracements & extensions (Fibs) extensively in my trading. Fibonacci sequence numbers (1,3,5,8,13,21,34,etc) have a fascinating relationship with growth rates in nature but that’s not why I rely on them for my trading. The fact is that many (if not most) trading algorithms are programmed to trade Fib levels as both retracements of a prior price move or as an extension of a current price move. Algo traders certainly aren’t the only market participants, there are also CTA’s, hedge funds, pension funds, option dealers, and retail traders, to name a few but, in my experience, it’s harder to predict the likely behavior of those traders. Algos seem more likely to follow a plan or playbook in their trading. The purpose of this post is to describe that playbook to you so that you can anticipate important potential levels of support or resistance when looking at a chart. As I said, algos aren’t the only participants in the market so you’ll get as much valuable trading information from a Fib level that fails as from one that successfully causes the market to reverse. In other words, if price fails to reverse at a 50% Fib retracement levels then it’s highly likely that price is going to proceed to test the 61.8% Fib level next. I can trade with that information! Think about it.
Below is the daily chart of Netflix (NFLX). On the chart I introduce the concept of 2 different types of traders; breakout/breakdown traders and retracement traders. I’m the latter! In this chart a breakdown trader might short NFLX when it broke down below the prior pivot low. The fact that price also closed on the low of the day would’ve been a sign of a very weak stock that should be shorted. A retracement trader would likely agree that the stock looked weak and should be shorted but would not agree that it was a good location to short the stock. The stock closed at 403 on the breakdown day but the retracement trader would’ve been looking to establish a short position in the 443-453 area. What? Where did that level come from? Read on to find out!
Below is the same daily chart but with the Fib retracement resistance zone added. I refer to the 50%-61.8% Fib retracement of a price move (either up or down) as the Fib zone. There are other important Fib retracement levels but from my experience the 50%-61.8% offers the best risk/reward setup. If you look at enough charts with the Fib levels shown I think you’ll agree with me. As of the close on the breakdown day this is what the chart with the Fib zone shown looked like.
Below is the same daily NFLX chart as of the close 3 days after the breakdown. I’ve redrawn the Fib levels because there’s been a lower-low for the price range from the high to the low of the current decline. That lower-low occurred the day after the breakdown day. One important thing to notice about that following day is that it had a lower-low than the breakdown day but it also opened near the low, spent the day rallying, moved back above the breakdown candle low and closed near the high of the day. Everything about that type of price action screams FAILED BREAKDOWN! That’s not a good time to be shorting a stock! In fact, that kind of price action will typically lead me to get long just prior to the close with a stop below the low of that day. But that’s another trade and, for the purpose of this post, I’m discussing where I would get short, not long. Moving on to the next chart…
10 days after the breakdown price finally reached the 50% Fib retracement of the prior decline. That’s good trade location to add some short Deltas. Since I find a retracement to the 61.8% Fib to be the BEST location for a short but since price often fails to retrace past the 50% level I’ll typically leg-into a short trade. I often initiate a half-size position at the 50% Fib and the other half gets added to the position IF price reaches the 61.8% Fib.
Didn’t have to wait very long for price to move through the 50% Fib to reach the 61.8% Fib, did I? It happened the very next day!
Below is the chart showing the price action for about 1 month following the bearish reversal that occurred within 1.63 points of the 61.8% Fib resistance level. As price began it’s decline from the wave 2 high I was able to use a Fibonacci extension tool to anticipate areas where algos would likely be resting buy orders. I can use those areas as a target for a short trade as well as an area to initiate a new long trade.
There’s all kinds of information regarding Fibonacci retracements and extensions on the internet and YouTube videos and most all trading platforms have the tools available. You can also follow me @VegaOptions on X (Twitter) to see plenty of discussion of the Fibs!
Update after I completed this post. I forgot to mention the Tesla (TSLA) chart. I don’t want anyone thinking that the Fibs just work on NFLX. They ‘work’ on anything that algos trade which is pretty much anything that trades! Read the comments on the chart.
Questions or comments? Leave them down below!