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We mentioned earlier that directional trends usually stop for retracements or corrections. Corrections can take several shapes and lengths.
A healthy correction is usually short in time and magnitude, and retraces no more than 50 percent of the prior trend.
Fibonacci retracement percentages or ratios are used to identify where the potential reversal levels for a correction are.
The Fibonacci Sequence
Fibonacci numbers are a sequence where each number is the sum of the two preceding ones: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144...
The key Fibonacci ratios used in trading are derived from this sequence: 23.6%, 38.2%, 50%, 61.8%, and 78.6%.
To apply Fibonacci retracements on a chart:
[Image: Chart showing Fibonacci retracement levels applied to an uptrend]
Image: Fibonacci retracements - Technical Analysis Tutorial
Fibonacci as Support and Resistance
Fibonacci levels act as dynamic support and resistance. In an uptrend, corrections often find support at the 38.2% or 61.8% levels before the trend resumes. The opposite is true for downtrends.
Several advanced chart patterns use Fibonacci ratios to identify high-probability trading setups. These patterns combine price structure with Fibonacci relationships.
The ABCD pattern is one of the most common harmonic patterns. It consists of three consecutive price swings that form specific Fibonacci relationships.
The ABCD pattern can be bullish (price moving up to point D) or bearish (price moving down to point D). At point D, traders look for reversal signals.
[Image: ABCD pattern showing points A, B, C, D with Fibonacci relationships]
Image: ABCD harmonic pattern example
Trading the ABCD Pattern
Entry: At point D when Fibonacci targets align
Stop Loss: Beyond point D
Target: Point C or the 61.8% retracement of CD
The three-drive pattern consists of three consecutive and symmetrical drives (price moves) in one direction. Each drive is followed by a correction.
The three-drive pattern is considered a reversal pattern. After the third drive completes and reaches its Fibonacci extension target, a reversal is likely.
⚠️ Pattern Validation
For three-drive patterns to be valid, the timing of each drive should be roughly symmetrical, and the Fibonacci relationships must align closely. Approximate is acceptable, but the pattern should be visually clear.
While Fibonacci retracements help identify where corrections might end, Fibonacci extensions help identify where the price might go after the correction completes.
Extension levels are used to project potential profit targets beyond the original price move. The most common extension levels are:
To apply Fibonacci extensions:
[Image: Chart showing Fibonacci extension levels projecting price targets]
Image: Fibonacci extensions for profit targets
Fibonacci Confluence
The most powerful Fibonacci signals occur when multiple Fibonacci levels from different swings converge at the same price area. This is called Fibonacci confluence and represents a high-probability support or resistance zone.
Fibonacci tools are best used in combination with other technical analysis methods. They work particularly well when combined with trend lines, support/resistance levels, and candlestick patterns. For real examples, check our performance archive where we often use Fibonacci analysis.