Introduction
There is a wide range of technical analysis (TA) tools and indicators that traders use to try to predict future price actions. This includes complete market analysis frameworks such as the Wyckoff Method, Elliott Wave Theory or Dow Theory. There are also other indicators such as Moving Averages, Relative Strength Index (RSI), Stochastic RSI, Bollinger Bands, Ichimoku Clouds, Parabolic SAR and MACD.
The Fibonacci Retracement tool is a popular indicator used by thousands of traders in the stock, forex and cryptocurrency markets. It's fascinating because it's based on the Fibonacci sequence discovered more than 700 years ago.
This article will cover the definition of the Fibonacci Retracement tool and how you can use it to find important levels on a chart.
What is Fibonacci Retracement?
The Fibonacci retracement (or Fib retracement) is a tool used by technical analysts and traders in attempting to predict areas of interest on a chart. They do this by using Fibonacci ratios as percentages. The Fibonacci retracement tool is derived from a series of numbers identified by mathematician Leonardo Fibonacci in the 13th century. This series of numbers is known as the Fibonacci sequence. Certain mathematical relationships between the numbers in this sequence create proportions that are plotted on a graph. These proportions are:
0%
23,6%
38,2%
61,8%
78,6%
100%
Although the 50% value is not technically a Fibonacci ratio, some traders also consider it when using the tool, as it represents the midpoint of the price range. Fibonacci ratios outside the range of 0 to 100% can also be used, such as 161.8%, 261.8% or 423.6%.
We will discuss how traders can use these percentages, but the bottom line is that the levels they describe can correlate with important levels in the market. When plotted on a price chart, Fibonacci levels can be used to identify areas of interest such as support, resistance, retracement areas, entry points, exit points, and stop-loss levels.
How to calculate Fibonacci Retracement
Since these percentages are the same across all Fibonacci retracement tools, you don't need to calculate anything manually. However, the way to obtain them is through Fibonacci numbers.
Let's create a sequence of numbers that starts with zero and one. Keep adding the sum of the last two numbers to get the next one. If we continue indefinitely, we will have a numerical sequence called the Fibonacci sequence.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987... and so on.Of course, these numbers are not directly plotted for a price chart. But the levels used in the Fibonacci retracement tool are all derived from these numbers in some way.
Disregarding the first numbers, if you divide one number by the next number, you will always get a ratio close to 0.618. For example, dividing 21 by 34, we have 0.6176. If you divide a number by what is two places to the right of it, you get a ratio close to 0.382. For example, dividing 21 by 55, we have 0.3818. All ratios (except 50%) in the Fibonacci retracement tool are based on some calculations involving this method.
The Fibonacci sequence and the Golden Ratio
As mentioned, the Fibonacci sequence was identified by mathematician Leonardo Fibonacci in the 13th century. The Golden Ratio (0.618% or 1.618%) is a mathematical proportion derived from these numbers. But why is this number so important?
The Golden Ratio describes the proportions of an incredibly long list of phenomena in the universe and can be found everywhere in nature. Think of atoms, stars, galaxy formations, shells and even bees – everything, from the smallest to the largest scales, can present examples of this proportion.
Additionally, it has been used by artists, engineers, and designers for centuries to create aesthetically pleasing compositions. From the pyramids to the Mona Lisa and even the Twitter logo, many famous works of art and design use the Golden Ratio in some way. It turns out that this ratio can also be useful in financial markets.
How to use Fibonacci Retracement
Now that we know what the Fibonacci retracement tool is and how it works, let's consider its use as a tool for financial markets.
Typically, the indicator is drawn between two important price points, such as a high and a low, for example. This range is used as a basis for further analysis. Generally, the tool is used to map levels within the range, but it can also provide information on important price levels outside the considered range.
This range is usually drawn according to the underlying trend. Therefore, in an uptrend, the minimum point would be 1 (or 100%), while the maximum point would be 0 (0%). By plotting Fib retracement lines over an uptrend, traders can get an idea of possible support levels that could be tested should the market begin to pull back – hence the term retracement.
On the other hand, during a downtrend, the minimum point would be 0 (0%) and the maximum point would be 1 (100%). Note that as the price is in a downtrend. In this example, the retraction movement refers to the retraction of the bottom – therefore it presents a bouncing effect. In this case, the Fibonacci retracement tool can provide information about possible resistance levels if the market starts to rise.
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What Fibonacci levels demonstrate to traders
Traders can use Fibonacci levels to determine possible entry areas, target price or stop-loss points. This can vary significantly depending on each individual's setup, strategy and trading style.
Some strategies seek to profit in the interval between two specific Fibonacci levels. For example, consider an uptrend followed by a pullback. Buying at the 38.2% retracement level and selling at the 23.6% level could be an interesting strategy. Of course, this also depends on the individual strategy and many other technical factors.
Fibonacci levels are also used in conjunction with Elliott Wave Theory to find correlations between wave structures and potential areas of interest. It can be an efficient strategy to predict the extent of pullbacks in different waves of a specific market structure.
As with other techniques, the Fibonacci retracement tool is most powerful when combined with other technical analysis indicators. What may, apparently, not be a buy or sell signal in itself, may end up being confirmed by other indicators. Therefore, if the price reaches a certain Fibonacci level, it may or may not undergo a reversal. Therefore, it is essential to manage risks while taking into account the market environment and other factors.
Fibonacci Extension
As mentioned, Fibonacci levels can be used to evaluate areas of retracement or bounce (number 1 in the animation below). Additionally, the Fibonacci sequence can also be used as a way to measure possible important levels outside the current range. These are called extension levels (number 2).
Fibonacci extension levels can be seen as possible trading targets. Each trader can choose a different extension level as a target (or several). The first extension levels are 138.6%, 150% and 161.8% – followed by 261.8% and 423.6%.
Therefore, Fibonacci extension levels may indicate areas where upcoming price movements may end – however, they should not be interpreted as direct trading signals.
Final considerations
Fibonacci numbers are found everywhere in nature and many traders believe they are very important in analyzing financial market charts.
However, as with any technical indicator, the relationship between price action, chart patterns and indicators is not based on any scientific principle or physical law. Therefore, the usefulness of the Fibonacci retracement tool may be related to the number of market users who are paying attention to it. So even though Fibonacci retracement levels don't necessarily correlate with anything tangible, they can act as a very useful tool when trying to predict areas of interest.
