What are Fibonacci Retracements?
Fibonacci Retracements are a tool used by technical analysts and traders in an attempt to predict areas of interest on a chart. To do this, they use Fibonacci ratios as percentages. The Fibonacci Retracement tool originates from a series of numbers identified by the mathematician Leonardo Fibonacci, hence its name.
This series is called the "Fibonacci sequence." Certain mathematical relationships between the numbers in this sequence generate ratios that are then depicted in a chart. These ratios are:
0%
23.6%
38.2%
61.8%
78.6%
100%
Although it is technically not a Fibonacci ratio, some traders consider the 50% level to also have some importance - given that it represents the midpoint of the price range. Fibonacci ratios outside the 0-100% range can also be used, such as levels 161.8%, 261.8%, or 423.6%.
How Fibonacci Retracements are calculated
Since these percentages are the same in each Fibonacci Retracement tool, you do not need to manually calculate anything. However, to understand them, one must start with the Fibonacci numbers.
These numbers, obviously, are not directly represented on a price chart. But all the levels used by the Fibonacci Retracement tool derive, in a way, from these numbers.
If you divide a number by the one that follows it, you will always get, except in the case of the first numbers in the series, a ratio close to 0.618. For example, if you divide 21 by 34, the result will be 0.6176. And if you divide a number by the one that follows it two places to the right, you will obtain a ratio close to 0.382. Thus, if you divide 21 by 55, the result will be 0.3818. All the ratios from the Fibonacci Retracement tool (except for the 50%) are based on a set of calculations that integrate this method.
The Fibonacci sequence and the Golden Ratio
As we have already discussed, the Fibonacci sequence was identified by the mathematician Leonardo Fibonacci in the 13th century. The Golden Ratio (0.618% or 1.618%) is a mathematical quotient derived from those numbers. But why is it such an important number?
The Golden Ratio describes the proportions of a surprisingly long list of phenomena in the universe, and can be found in nature everywhere. Think of atoms, stars, galactic formations, shells, and even bees – everything, from the smallest scales to the largest, can present examples of this proportion.
How to use Fibonacci Retracements
Now that we know what Fibonacci Retracements are and how they work, let's see how they are used as a tool in financial markets.
Typically, the tool is drawn between two significant price positions, such as a peak and a trough. This range is then used as a basis for deeper analysis. Normally, the tool is used to map levels within the range, but it can also provide hints about important price levels outside of it.
Typically, this range is drawn according to the underlying trend. So, in a bullish trend, the low point would be 1 (or 100%), while the high point would be 0 (0%). By plotting Fibonacci retracement lines over a bullish trend, traders can get an idea of the possible levels that may be tested if the market begins to retrace, hence the term retracement.
Conversely, during a bearish trend, the low point would be 0 (0%) and the high point 1 (100%). Keep in mind that since the price is in a bearish trend, the retracement in this case refers to the retracement from the bottom, which is, in effect, a bounce. In this case, the Fibonacci retracement tool can provide insight into potential levels if the market begins to rise.
Fibonacci applied to reality
Traders can use Fibonacci levels to determine possible entry areas, price targets, or stop-loss points. This can vary significantly based on individual setup and strategy.
Some strategies involve taking profits in the range between two specific Fibonacci levels. For example, consider a bullish trend followed by a retracement. Buying at the 38.2% retracement level and then selling at the 23.6% level could be an interesting strategy. This is, of course, highly dependent on individual strategy and many other technical factors.
Like other techniques, the Fibonacci retracement tool is more powerful when combined with other indicators. What may not be a buy or sell signal on its own could become one if confirmed by other indicators. As such, if the price reaches a specific Fibonacci level, it may reverse or not. Therefore, it is essential to understand risk management while also taking other factors into account.
Fibonacci Extensions
As mentioned, Fibonacci levels can be used to assess retracement or bounce areas. But in addition to that, the Fibonacci sequence can also be used as a way to measure potentially important levels outside the current range called extension levels.
Fibonacci extension levels can be seen as possible trading targets. Each trader can choose a different extension level as a target or multiple targets. The first extension levels are 138.6%, 150%, and 161.8%, followed by 261.8% and 423.6%.
Therefore, Fibonacci extension levels can indicate areas where the next price movements could end; however, they should not be interpreted as direct trading signals.
