What is Fibonacci Retracement?
Fibonacci retracement is a popular method in technical analysis that uses ratios to determine support and resistance levels. These ratios are derived from the Fibonacci sequence, which consists of key numbers identified by mathematician Leonardo Fibonacci. Fibonacci retracement is based on the idea that markets will retrace a portion of its original move in price before continuing its original trend. Whether they are trading stocks, commodities or even day trading the forex market, the Fibonacci retracements pattern can be useful to swing traders in identifying potential reversal levels and setting price targets and stop losses.
Popular Fibonacci Ratios
There are many different Fibonacci ratios that technical analysts use to determine retracement levels. However, the popular Fibonacci ratios are 0%, 23.6%, 38.2%, 50%, 61.8% and 100%. Technical analysts use Fibonacci ratios to identify retracement levels and predict the extent of a correction or pullback.
How do we come up with these ratios? First, it helps to have some knowledge on the Fibonacci Sequence. It is unnecessary to examine the mathematical properties behind the sequence but we will cover the basics as to how the ratios are derived.
What is The Fibonacci Sequence?
The Fibonacci Sequence is a series of numbers where each number is simply the sum of the two preceding numbers. The sequence is 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 and so on. A significant characteristic of this sequence is that each number is approximately 1.618 times greater than the preceding number. The approximation becomes closer to 1.618 as the numbers increase. 1.618 is actually referred to as the Golden Ratio. This common relationship between each number is the basis of the popular ratios used in the Fibonacci retracement method.
How Are the Fibonacci Ratios Derived?
Some traders avoid using the Fibonacci analysis because they think it involves complex mathematics. However, I will break the method down for you step-by-step and you will see that it’s not that complicated after all. For your knowledge, here is how the common Fibonacci ratios are derived:
61.8% – A number divided by the next highest number approximates 0.618 (13/21=0.6190, 21/34=0.6176, etc.
38.2% – A number divided by a number two places higher approximates 0.382 (13/34=0.382, 21/55=0.3818, etc.)
23.6% – A number divided by a number three places higher approximates 0.236 (13/55=0.2363, 21/89=0.2359, etc.)
The 50% ratio does not relate much to the Fibonacci sequence, but traders use this level because of the tendency for stocks to reverse after retracing half of the previous move, as assumed by the Dow Theory.
There are many other ratios that traders use, such as 47.2%, 76.4% or 78.6%. The decision to use a certain ratio is a personal choice. You should test different ratios and decide which ones work for you.
Fibonacci Retracements Pattern
Retracements are based on prior moves. In a downtrend, a bounce retraces a percentage of the decline. In an uptrend, a correction retraces a percentage of the rally. Once a pullback occurs, technical analysts can determine specific Fibonacci retracement levels to monitor.
The below picture depicts the Fibonacci retracements pattern. When a stock uptrends (A), it can retrace part of that move (B), before moving on in its original trend (C). Swing traders watch these retracements, or pullbacks, for opportunities to buy and sell. However, just because a stock retraces 38.2% does not mean you should automatically buy the stock! How do you know the stock won’t go down further and retrace 50%? Instead, plot the Fibonacci retracement levels and look for signs of reversals before making any purchasing decisions. Check out further examples on how to identify Fibonacci Retracements.
Calculating Fibonacci Retracement Levels
To calculate Fibonacci levels, take the range of two extreme points, such as a major peak and a major trough and multiply the range by a Fibonacci ratio. Then, subtract the result from the price of the major peak. This will give you the Fibonacci level. For example, assume the lowest price of a stock was $15 and the highest was $29. The range between these two extreme points is $14. Multiply the range of $14 by the Fibonacci ratio of 38.2% and subtract the result from $29. This will give you $23.65, which is one of the Fibonacci levels. If the stock continues to retrace its move to 50%, the stock price will go down to only $22. Similarly, the 61.8% level would be $29 – (0.618 x $14) = $20.34.
The 0% level is considered to be the start of the retracement, which would be $29 and the 100% level is a complete reversal of the original move, which would be $15.
The Golden Ratio
A 23.6% retracement is relatively a short pullback. Retracements in the 38.2% – 50% range are considered moderate. The 61.8% Fibonacci ratio is referred to as the Golden Ratio or the Golden Mean. Although shallow retracements like a 23.5% retracement can occur, 38.2% – 61.8% covers more possibilities.
Keep in mind that retracement levels do not equal reversal points. Instead, they simply signal a potential reversal. Traders can use other technical signals, such as candlesticks or volume, to confirm the reversals points. The more technical indicators signal the same thing, the stronger the signal.
Eventually, you will be able to just look at a chart and estimate where the levels are. However, physically draw the lines on a chart if it helps you to better visualize the Fibonacci levels.
To learn more about Fibonacci, check out this Fibonacci Trading Strategy Webinar.