The topic of Fibonacci retracements is quite intriguing. To fully understand and appreciate the concept of Fibonacci retracements, one must understand the Fibonacci series. The origins of the Fibonacci series can be traced back to the ancient Indian mathematic scripts, with some claims dating back to 200 BC. However, in the 12th century, Leonardo Pisano Bogollo, an Italian mathematician from Pisa, known to his friends as Fibonacci discovered Fibonacci numbers.
The Fibonacci series is a sequence of numbers starting from zero arranged so that the value of any number in the series is the sum of the previous two numbers.
Fibonacci retracement levels are horizontal lines that indicate the possible support and resistance levels where the price could potentially reverse direction.
The first thing you should know about the Fibonacci tool is that it works best when the market is trending.
The idea is to go long (or buy) on a retracement at a Fibonacci support level when the market is trending UP.
And to go short (or sell) on a retracement at a Fibonacci resistance level when the market is trending DOWN.
Fibonacci retracement levels are considered a predictive technical indicator since they attempt to identify where the price may be in the future
The Fibonacci sequence is as follows: Calculation
0 , 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610…
Notice the following:
233 = 144 + 89
144 = 89 + 55
89 = 55 +34
Needless to say, the series extends to infinity. There are a few interesting properties of the Fibonacci series.
Divide any number in the series by the previous number; the ratio is always approximately 1.618.
For example:
610/377 = 1.618
377/233 = 1.618
233/144 = 1.618
The ratio of 1.618 is considered as the Golden Ratio, also referred to as the Phi. Fibonacci numbers have their connection to nature. The ratio can be found in the human face, flower petals, animal bodies, fruits, vegetables, rock formations, galaxy formations etc. Of course, let us not get into this discussion as we would be digressing from the main topic. For those interested, I would suggest you search on the internet for golden ratio examples, and you will be pleasantly surprised. Further into the ratio properties, one can find remarkable consistency when a number in the Fibonacci series is divided by its immediate succeeding number.
For example:
89/144 = 0.618
144/233 = 0.618
377/610 = 0.618
At this stage, do bear in mind that 0.618, when expressed in percentage is 61.8%.
Similar consistency can be found when any number in the Fibonacci series is divided by a number two places higher.
For example:
13/34 = 0.382
21/55 = 0.382
34/89 = 0.382
0.382, when expressed in percentage terms, is 38.2%
Also, consistency is when a number in the Fibonacci series is divided by a number 3 places higher.
For example:
13/55 = 0.236
21/89 = 0.236
34/144 = 0.236
55/233 = 0.236
0.236, when expressed in percentage terms, is 23.6%.
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Strategies for Trading Fibonacci Retracements
There are no restrictions on the time frames that you can use Fibonacci ratios. You should feel just as comfortable using this technique on intra-day data as you would on daily or weekly prices.
The golden ratios will work on all periods you decide to analyze. You can use Fibonacci numbers as a method for finding support and resistance levels, as well as for risk management.
You can predetermine your stop loss level and take profit targets using Fibonacci retracements before you enter a trade
You can also use Fibonacci Retracement levels in conjunction with other studies such as moving averages that can act as a confirmation indicator.
For example, following a short-term moving average crossover where the 5-day moving average crosses above the 20-day moving average, you could wait until the S&P 500 index breaks through the 38.2% retracement before entering your trade.
You can also see resistance near the 200-day moving average which coincides with the initial resistance the S&P 500 index experienced at the 61.8% retracement level.
Bottom Line
Fibonacci retracements trace their roots back to Fibonacci numbers which were discovered centuries ago and developed into a technical analysis tool.
The Fibonacci retracements are calculated by using common Fibonacci ratios which are calculated from the Fibonacci sequence.
You can use the Fibonacci retracements to uncover support and resistance levels which can be used as targets to either stop out of a position or take profit on a trade.
Additionally, you can use these target levels as confirmation indicators used in conjunction with other technical indicators such as moving averages, stochastics, and momentum.
The most common Fibonacci ratios are the 38.2% ratio and the 61.8% ratio. Other ratios are also used, such as the 50% ratio first described in Dow Theory, as well as the 23.6% ratio, which represents a short-term target.
Fibonacci retracements can be used as a risk management tool. The targets can be used to determine your risk versus reward ratio before entering a trade, as well as, an active management tool to uncover new levels of support and resistance.
One of the most important concepts that are uncovered by the Fibonacci retracements is periods when the market is likely to consolidate.
These levels initially do not provide a gauge of whether the market is pausing only to refresh or reversing. When prices begin to consolidate around a Fibonacci level, a retest of the level will be inevitable.
If prices continue to trend through the 38.2% retracement they are likely to test the 61.8% retracement
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How should you use the Fibonacci retracement levels?
Think of a situation where you wanted to buy a particular stock, but you have not been able to do so because of a sharp run-up in the stock. The most prudent action to take would be to wait for a retracement in the stock in such a situation. Fibonacci retracement levels such as 61.8%, 38.2%, and 23.6% act as a potential level up to which a stock can correct.
By plotting the Fibonacci retracement levels, the trader can identify these retracement levels, and therefore position himself for an opportunity to enter the trade. However please note like any indicator, use the Fibonacci retracement as a confirmation tool.
I would buy a stock only after it has passed the other checklist items. In other words, my conviction to buy would be higher if the stock has:
- Formed a recognizable candlestick pattern
- The stop loss coincides with the S&R level.
- Volumes are above average.
Along with the above points, if the stop loss also coincides with the Fibonacci level, I know the trade setup is well aligned to all the variables, and hence I would go in for a strong buy. The word ‘strong’ usage indicates the level of conviction in the trade set up. The more confirming factors we use to study the trend and reversal, more robust is the signal. The same logic can also be applied to short trade.
Key takeaways from this chapter
- The Fibonacci series forms the basis for a Fibonacci retracement
- A Fibonacci series has many mathematical properties. These mathematical properties are prevalent in many aspects of nature.
- Traders believe the Fibonacci series has its application in stock charts as it identified potential retracement levels.
- Fibonacci retracements are levels (61.8%, 38.2%, and 23.6% ) up to which a stock can retrace before it resumes the original directional move.
- At the Fibonacci retracement level, the trader can look at initiating a new trade. However, before initiating the trade, other points in the checklist should also confirm
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