Every experienced trader has at some point used Fibonacci retracements. Some resort to it on a regular basis, while others do it only occasionally. The frequency of use does not really matter if one utilizes this powerful tool correctly every time. The improper application of technical analysis methods will result in bad timing of entry and exit points and thus, mounting losses. In this article, we will show the wrong ways of applying Fibonacci retracements and point out their correct alternatives.
Mistake #1: Inconsistency In the Choice Of Reference Points
When applying Fibonacci retracements, it is important to keep the reference points consistent. This means that the highest and lowest points of a trend should be referenced wick to wick or candle body to candle body, but not wick to body or vice versa. Failure to do so results in incorrect, often random, levels of support and resistance, which creates a much lower chance to time the market correctly.
The SPX500 chart below pictures this error. The use of the candle wick at the top and the body of the candle at the bottom part of the trend leads to wrong identification of the resistance levels. The 50% and 61.8% Fibo retracements of the fall from $3,233 to $2,936, for this reason, do not act as true technical levels, which can be clearly seen on the chart: the price action goes up and down through these levels, thus indicating that they do not work.
On the chart below you can see that if correctly applied, the Fibonacci retracements provide valuable insights where the correction might lose steam, identifying the key technical levels.
Mistake #2: Failure to Identify and Consider Long-Term Trends
It is pretty common for inexperienced traders to fail to distinguish the long-term market trend from the short-term fluctuations. This narrow perspective often catches them off guard, betting against the prevailing market move. Being aware of the long-term trend guarantees that one will at least apply Fibonacci retracements in the correct direction.
The example with EUSTOXX50 below clearly demonstrates how important it is to identify the direction of the long-term trend. The index was having an eye-watering rally that stopped at €3,400. The correction which unfolded afterwards stopped precisely at the 50% Fibo, corresponding to €3,050, which was the perfect chance to go long and enjoy a more than €230 ride up.
After the strong rally of the European benchmark some might have been mistaken that the trend has been reversed, thus applying the Fibonacci retracements in the opposite direction. As you can see on the chart below, this has proved to be a losing strategy, as the index has consecutively violated the 23.6%, 31.8%, 50% and 61.8% levels. So if traders had been shorting on any of them, they were clearly under water as of the time this screenshot was made.
Mistake #3: Using Fibonacci Retracements For Short-Term Moves
The volatility which day trading entails often makes applying Fibonacci ineffective. The shorter time frame makes retracement levels less reliable, as volatility often skews support and resistance levels. This in turn makes picking the correct levels to trade based on Fibonacci analysis pretty hard. The situation is further aggravated by the presence of spikes in the short-term. The latter can in most cases be attributed to the release of important economic/financial data figures throughout the day.
It should be kept in mind that, as with any other statistical study, the longer the observed period (the more data used), the stronger the implications of the analysis. The Fibonacci sequences make no exception in this respect. So, applying the Fibonacci retracements to longer time frames will yield more reliable price levels.