How to Use Fibonacci Retracement with Gold and Silver Trading

What are Fibonacci Retracement Levels?

Fibonacci retracement theory is a technical approach to trading that uses a set of specific proportions to determine the likely size of a price change relative to a previous change, providing expected support and resistance levels. 

It can therefore be used as a guide for traders to identify entry and exit points in the market, or for placing stop-loss positions that aim to manage risk by limiting losses. 

A quick history lesson: Fibonacci, also known as Leonardo Bonacci and Leonardo Bigollo Pisano, was a 12th and 13th century Italian mathematician from the Republic of Pisa. He introduced to Europe the idea of a sequence of numbers, thought to have derived from Indian mathematicians as early as the sixth century. 

In this sequence of numbers, later known as ‘Fibonacci numbers’ or the ‘Fibonacci sequence,’ each value is the sum of the previous two values. This gives the beginning of the sequence as: 1, 2, 3, 5, 8, 13, 21, 34 and so on. 

As the numbers rise, the proportion between each number gets closer to what is called the ‘golden ratio’ or ‘golden section.’ This proportion is approximately 1 to 1.618 and is a proportion widely found in nature, from the way petals are arranged on a flower, to the growth of plants, to the sections found in a snail’s shell.

The golden ratio is thought to give a harmonious balance that is considered aesthetically pleasing and hence was incorporated into great works of art.

Why does this matter for trading markets? After moving between two extremes, the price of any commodity tends to swing in either direction as the market tries to find a new balance. This is where Fibonacci retracement can help provide a framework for understanding where the price might be headed next.

Fibonacci retracement theory relates to the price of a commodity after having moved between two extremes. The theory holds that the size of a price retracement tends to correspond to the proportions embedded in the Fibonacci sequence. An important caveat: some traders do make use of Fibonacci retracement theory, while others ignore it.

How to Draw Fibonacci Retracement Levels

Most modern-day chart tools allow the user to superimpose trend lines and other technical pointers onto a price chart with simple on-screen functions, and some market analysis tools include an option to view Fibonacci levels, without any need for making any calculations. 

But if you were to do this by hand, you would start with the price recorded as the most recent long-term high, followed by the most recent low. Subtracting the low from the high would give you the size of this total price movement. Then you would apply Fibonacci levels to this overall price movement to provide a guide for the size of any likely retracements. 

The key proportions in Fibonacci retracement are 23.6%, 38.2%, 61.8% and 78.6%. 50% is also sometimes used but is not part of the sequence itself. Each value is therefore a percentage of the prior move and can be plotted on a price chart as horizontal lines.

How to Use Fibonacci Retracement

Let’s use a worked example for gold prices. Let’s say the spot price of gold last peaked at $2,130 an ounce and had more recently fallen to a low of $1,865 an ounce. The size of this total move from peak to trough is $265. 

As the price begins to recover from the low, a trader wants to understand the size of any expected upward retracement in the price. Fibonacci theory holds that key levels to watch would be 23.6% of the overall move, which means a $62.54 gain from the low of $1,865, which gives $1,927.54.

These levels are plotted on the chart as horizontal lines. The other price levels implied by Fibonacci proportions in this particular example would be $1,966.23 (38.2%), $2,028.77 (61.8%) and $2,073.29 (78.6%).

Fibonacci Trading Strategy Examples

Various approaches can be used to deploy Fibonacci retracements in trading strategies. Examples include: 

• Using Fibonacci retracement levels to identify potential trend channels after a big price move higher or lower.
  
• Buying near the 32.8% retracement level and setting a stop-loss order at just below the 50% level.
  
• Buying near the 50% retracement level and placing a stop-loss order at just below the 61.8% level.

These strategies can help a trader identify entry and exit points by using Fibonacci retracement levels to understand where support and resistance could occur after long-term highs and lows have been established.

Pros and Cons of Fibonacci Retracement Strategies

Pros: Fibonacci retracement theory can help traders and analysts understand where support and resistance may lie, and where potential price reversals may occur, providing a framework that can help develop a trading strategy.

It is widely used and therefore worth considering as part of a more comprehensive trading strategy. Chart analysis tools providing functions to superimpose Fibonacci retracement levels on price charts are widely available, and traders can also calculate these levels independently with a minimal effort involved.

Cons: Some market observers have back-tested Fibonacci retracement levels on real world movements of commodities and stock indices and claim to have found no statistically significant correlation between the theory and how markets have actually performed, raising doubts over their value.

Conclusion

Few traders would stack their entire book on the basis of Fibonacci retracement levels, and for obvious reasons: there is no law that requires commodity prices or stock index movements to correspond with Fibonacci proportions. 

That said, Fibonacci retracement theory certainly has its place in the pantheon of technical analysis tools, alongside Elliott Wave Theory, Bollinger Bands, Relative Strength Index, Moving Average Convergence/Divergence (MACD), Japanese candlestick formations and a host of other technical analysis approaches.

However, before deploying Fibonacci retracement theory, any professional trader would be expected to have developed a solid understanding of:

• The physical supply and demand fundamentals of their market
• The regulatory frameworks in which the market resides
• The price impacts that rule changes can have
• The effects of market sentiment and the influence of wider financial markets
• The effect of currencies
• The effect of monetary policy/interest rates
• The effect of freight rates (for physical commodities requiring shipping)
• The risks associated with geopolitical tensions and/or conflict
• Weather impacts affecting mining operations and/or transport of physical commodities
• Other political and civil influences, for example labour disputes and worker strikes

For a professional trader, Fibonacci retracement theory can help augment a more comprehensive trading strategy that may include several other technical analysis tools.

When deployed together, these could form a valuable set of tools to help understand price movements, estimate a future price trend channel, and to identify potential entry and exit points or suitable level for placing stop-loss orders.