Fibonacci retracements are horizontal lines that specify where support and resistance can arise. They result from the Fibonacci sequence, a mathematical formula conceived in the 13th century.
In the Fibonacci sequence, each level is related to a percentage. The percentage implies how much of a previous move the price has retraced. 23.6%, 38.2%, 61.8% and 78.6% are the Fibonacci retracement levels. 50% is not officially a Fibonacci ratio, but it is still used.
The indicator is helpful in the light that it can be made between any two considerable price points, such as a high point and a low point. The indicator then forms the levels between those two points.
Fibonacci retracement lines reflect crucial areas where a stock may reverse or stall in technical analysis. The standard ratios comprise 23.6%, 38.2%, and 50%, apart from others. They will come between a high point and a low point for a stock. They are made to anticipate the future direction of their price movement.
Understanding Fibonacci Sequence and Series
The topic of Fibonacci retracements is actually fascinating. To completely comprehend the idea of Fibonacci retracements, you must understand the Fibonacci series.
A series of numbers that begins from zero is arranged so that the value of any number in the series is the sum of the preceding two numbers. This series is known as the Fibonacci series.
The Fibonacci sequence is mentioned as follows:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610…
Take the following into notice:
233 = 144 + 89
144 = 89 + 55
89 = 55 +34
As might be expected, the series continues to infinity. The properties of the Fibonacci series are pretty interesting.
Divide any number in the series by its previous number. At all times, the ratio is nearly 1.618.
610/377 = 1.618
377/233 = 1.618
233/144 = 1.618
The ratio of 1.618 is regarded as the Golden Ratio, also referred to as the Phi. The ratio can be seen in the human face, flower petals, animal bodies, fruits, vegetables, rock formations, galaxy formations, and so on. In short, the Fibonacci numbers have a relationship with nature. Moreover, you can find fantastic consistency in the ratio properties when a numerical in the Fibonacci series is divided by its following number.
89/144 = 0.618
144/233 = 0.618
377/610 = 0.618
At this point, recall that 0.618 is 61.8% when denoted in percentage.
The same consistency can be seen when any number in the Fibonacci series is divided by a number two places higher.
13/34 = 0.382
21/55 = 0.382
34/89 = 0.382
0.382 is 38.2% when indicated in percentage terms.
After this, consistency is when a number in the Fibonacci series is divided by a number 3 places higher.
13/55 = 0.236
21/89 = 0.236
34/144 = 0.236
55/233 = 0.236
0.236 is 23.6% when denoted in percentage terms.
Read more about it here.
Use Case of Fibonacci Retracement in Technical Analysis
It is supposed that the Fibonacci levels 61.8%, 38.2%, and 23.6%, have their application in stock charts. Fibonacci technical analysis can be involved when there is an apparent up-move or down-move in prices. Whenever the stock moves either upwards or downwards sharply, it usually retraces back before its subsequent move. For instance, if the stock has gone up from Rs.50 to Rs.100, it is likely to return to maybe Rs.70 before moving to Rs.120.
Read more: technical analysis indicators
The ‘retracement level forecast’ is a method that can recognize up to which level retracement can occur. These retracement levels give a promising opportunity to penetrate new positions in the trend direction for the traders. The Fibonacci retracement lines at 61.8%, 38.2%, and 23.6%, enable the trader to recognize the retracement’s possible expanse. The trader can utilize these levels to position themselves for trade.
Have a look at the chart below:
The two encircled points on the chart are the point where the stock started its rally, which is Rs. 380, and the point where the stock prices peaked, which is Rs. 489.
The move of 109 (380 – 489) is the Fibonacci up-move. As per the theory of the Fibonacci level, after the up-move, you can anticipate a correction in the stock to stay up to the Fibonacci ratios. For instance, 23.6% could be the first level the stock can correct. If this stock goes on to correct further, the trader can be cautious about the 38.2% and 61.8% levels.
Look at the example shown below.
The stock had retraced up to 61.8%, which coincided with 421.9 before it got back to the rally.
You can reach 421 by using simple maths as well.
Total Fibonacci up-move = 109
61.8% of Fibonacci up-move = 61.8% ✕ 109 = 67.36
Retracement at 61.8% = 489 — 67.36 = 421.6
Similarly, you can compute the retracement for 38.2%, so on for other ratios as well.
In another instance, the chart has rallied from Rs.288 to Rs.338. This 50 points move makes up for the Fibonacci up-move. The stock retraced back 38.2% to Rs.319 before continuing its up-move.
The Fibonacci retracements can also recognize the levels up to which the stock can bounce back in cases of falling stocks. In the chart below, the stock began to fall from Rs. 187 to Rs. 120.6, making 67 points as the Fibonacci down-move.
After the down-move, the stock tried to bounce back, retracing back to Rs.162, which is the 61.8% Fibonacci retracement level.
Fibonacci Retracement Construction
As you understand at this point, Fibonacci retracements vary against the trend. To use the Fibonacci retracements, you should first identify a 100% Fibonacci move. The 100% move could be an upward rally or a downward rally. It would help if you chose the most recent peak and trough on the chart to mark the 100% move. Once this is identified, you have to connect them using a Fibonacci retracement tool, available in the majority of the technical analysis software. This is explained in the guide below:
Identify the immediate peak and trough. Here, the trough is at 875.42, while the peak is at 2362.41.
Choose and use the Fibonacci retracement tool among the chart tools.
Using the Fibonacci retracement tool, connect the trough and the peak.
After selecting the Fibonacci retracement tool from the charts tool, the trader must click on the trough first and drag the line to the peak. Simultaneously, the Fibonacci retracement levels begin to get plotted on the chart.
You can see at this point that the Fibonacci retracement levels can be computed and loaded on the chart. Utilize this information to position yourself in the market.
The formula for Fibonacci Retracement Levels
Here are the 4 main formulas to calculate Retracement and extensions through the Fibonacci Retracement formula –
Uptrend Retracement = High Range (H) – [(High Range (H) – Low Range (L)) * Fibonacci Retracement (FR) percentage]
Downtrend Retracement = Low Range (L) + [(High Range (H) – Low Range (L)) * Fibonacci Retracement (FR) percentage]
Uptrend Extension = H + [(H – L) * Fibonacci Retracement (FR) percentage]
Downtrend Extension = L + [(H – L) * Fibonacci Retracement (FR) percentage]
How to Calculate Fibonacci Retracement Levels?
Let us understand how you can calculate the Fibonacci Retracement levels with the formula as discussed above.
Assuming the high range is 1,000 and low range of a stock is 900. The Fibonacci percentage we are considering is 23.6%.
Putting these numbers in the formula we get –
Uptrend Retracement = 1000 – [(1000-900)*23.6%] = 976.4
Downtrend Retracement = 900 + [(1000-900)*23.6%] = 923.6
This means, the stock trending between the range 1000 and 900 will retrace back to 976.4 during an uptrend and to 923.6 during a downtrend before continuing in the market’s trend direction.
Why a Trader Should Understand Fibonacci Retracement Levels?
Whenever a sharp move is experienced in the stock price, either upward or downward, it usually has a high possibility of a pullback before continuing in the direction of the primary trend.
For instance, when a stock moves from Rs 100 to Rs 200, it may witness some pullback to 170 before moving to higher, such as 250.
Fibonacci analysis has its utilization in the stock market. It can be employed when you expect a correction after a sharp up-move or a down-move.
It helps you identify significant halts or probable bounce-back levels after a decline or advance.
These Fibonacci retracement levels present a good opportunity for the traders to make new positions in the trend direction.
23.6%, 38.2%, 50%, and 61.8% are the important Fibonacci retracement levels. According to the identified results, they help traders identify the probable extent of the retracement and position themselves for the trade.
Mostly, 23.6% retracement is relatively shallow and suitable for flag breakouts or short-term pullbacks.
On the contrary, 61.8% retracement is comparatively deeper, known as the golden ratio, and is a fundamental level. But, in the range of 38.2%-50%, retracements could be considered a moderate correction.
If the stock bounces back from 38.2% retracement, then the underlying strength of the previous move is usually considered vital. You can try out the Fibonacci retracement calculator to have a good idea of the concept.
The trader can identify these retracement levels by plotting the Fibonacci retracement levels. Therefore, they can position themselves for an opportunity to enter the trade. However, please note that use the Fibonacci retracement as a confirmation tool along the lines of any indicator. Purchase a stock only after it has passed the other framework elements. Put differently, the imperative conditions should be fulfilled if you want to buy a stock:
- A recognizable candlestick pattern
- The stop loss coinciding with the S&R level
- Above-average volumes
Read more: Top candlestick patterns you should know
Adding to the above points, if the stop loss also coincides with the Fibonacci level, then it means that the trade setup is conformed to all variables. Consequently, it means that a strong buy is preferred — the more confirming factors to study the trend and reversal, the more confident the signal. The same logic holds for a short trade.
Pros and cons of Fibonacci retracements
Pros of using Fibonacci Retracements –
- It helps traders identify the support and resistance levels that indicate potential market trends
- Allowed traders to understand the right time to close or open a market position
- Since the retracement levels can be drawn between any two price points, it helps you create levels between any two prices in the stock’s chart and identify price signals between them
- This indicator can be used by all types of traders – day traders, swing traders, technical traders, and even long term traders
Cons of using Fibonacci Retracements –
- Even though the retracement levels provide the traders with support and resistance levels, there is no guarantee that the prices are going to stop increasing or decrease at those levels
- Since there exist so many retracement levels, it becomes tough for the trades to identify which one is the right one that will work in their favor.
- Since this particular indicator is a little complicated to be understood, not all the traders in the stock market are able to make the correct use out of it
Fibonacci Retracements vs. Fibonacci Extensions
Fibonacci retracements apply percentages to a pullback, whereas Fibonacci extensions apply percentages to a move in the trending direction. For instance, a stock goes from $5 to $10 and then moves to $7.50. The move from $10 to $7.50 represents a retracement. If the price begins rallying again and goes to $16, it is called an extension.
Limitations of Using Fibonacci Retracement Levels
Though the retracement levels demonstrate where the price might find support or resistance, there are no guarantees the price will stop there. For this reason, other confirmation signals are often used, such as the price beginning to bounce off the level.
There is another argument against Fibonacci retracement levels. There are many retracement levels, and thus, the price is likely to reverse near one of them quite often. Traders often find it challenging to identify the useful one at any particular time. When it doesn’t pan out, it can always be claimed that the trader should have been looking at another Fibonacci retracement level relatively.
The Fibonacci ratios are obtained from the Fibonacci sequence. Here, each number equals the addition of the two previous numbers. Fibonacci ratios are formed using mathematical relationships found in this formula. As a consequence, they produce the following ratios: 23.6%, 38.2%, 50% 61.8%, 78.6%, 100%, 161.8%, 261.8%, and 423.6%. Although 50% is not a pure Fibonacci ratio, it is still used as a support and resistance indicator.
The Bottom Line
The Fibonacci series establishes the base for a Fibonacci retracement. Traders think the Fibonacci series has its application in stock charts as it recognizes possible retracement levels. Fibonacci is one of the beneficial methods to assess your chart.
At the Fibonacci retracement level, the trader can look at beginning a new trade. However, it doesn’t give a precise entry point and instead gives an estimated entry area. Also, there is no assurance that the price will reverse from any particular Fib level. Therefore, you should incorporate it with other technical parameters as a confirmation. Before beginning the trade, other points in the framework should also confirm.
Are Fibonacci retracements reliable?
Fibonacci retracements are considered to be the most accurate and reliable in longer timeframes. However, they can also be used in shorter time frames but provide reliable values when combined with other indicators.
What are the best Fibonacci levels?
61.8% and 38.2% are considered as the most popular Fibonacci retracement levels.
What is the golden ratio strategy?
This strategy helps in describing expected patterns not only in the stock market but everything around us – from humans, nature, galaxies to atoms. It is derived from the Fibonacci sequences and hence is significant in the financial markets as well.