Fibonacci Retracement

Introduction

The Fibonacci Retracement levels have their name derived from the Italian mathematician named Leonardo Pisano Bigollo who was also famously known by Leonardo Fibonacci.

But interestingly enough he didn’t create the Fibonacci sequence as he only introduced those numbers to western europeans after discovering them from Indian merchants.

Some scholars even suggest that the Fibonacci retracement levels were first formulated as far back as 700 BCE and 100 AD in ancient India with others yet estimating between 480 to 410 BCE but no one really knows the exact date.

Fibonacci numbers can be found across nature but a lot of traders are of the belief that such numbers may have some type of relevance within financial markets as well.

What is Fibonacci Retracement?

So what are the Fibonacci retracement levels even supposed to be? Well they’re prices! and they’re depicted as these horizontal lines on charts that can indicate support and resistance or rather where they’re likely to happen.

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The Purpose of Fibonacci Retracement

Every price level can be associated with this percentage amount that is supposed to measure how much retracement has happened from earlier peaks within price action.

The retracement amounts tend to be based on numbers that can be identified within a Fibonacci sequence and so the Fibonacci retracement levels have for a while been 38.2%, 23.6%, 61.8% and 78.6%.

Though not being an official Fibonacci ratio 50% is also utilized.

The indicator can be useful due to how it’s drawn between any two substantial price points like a low and a high with the indicator then creating levels between the two points.

So imagine the price of this certain stock increased to $10 but then lowered to $2.36 so in that case you have a retracement of 23.6% and that happens to be a Fibonacci number.

How is Fibonacci Retracement Calculated?

Fibonacci retracement levels don’t have any formulas as once those indicators have been applied to the chart it is you who has to select two points and after those have been chosen the lines can then be made at percentages of the move.

Fibonacci Retracement Calculation Steps

As we’ve already told you earlier the retracement levels don’t need any big calculation as they’re just percentages of what price range you chose but theres no denying one thing at least on our part and that the origin of these Fibonacci numbers can be fascinating.

They’re based on this thing known as the Golden Ratio. Just begin this sequence of numbers containing only zero and one and after that keep on adding the previous two numbers and eventually you’ll get a string that looks a little something like this, 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377….. which goes on indefinitely mind you.

Key Fibonacci Retracement Levels

The Fibonacci retracement levels have all been derived from that very number string above and once that sequence starts going dividing one number with the next will yield 0.618 or 61.8%.

Divide a number with the second number towards its right and the result will be 0.382 or 38.2% and so every single ratio maybe except for 50% is based some kind of mathematical calculation that involves this number string.

Interestingly enough the Golden Ratio of 1.618 or 0.618 can be found within sunflowers, shells, some historical artifacts and even galaxy formations and some architecture.

How to Use Fibonacci Retracement in Trading

You must have some idea about what the Fibonacci Retracement levels are supposed to be by now which is why you might be more interested in how you may actually use it within your trading and if that’s the case then look no further as that’s precisely what will be discussed below.

Identifying Support and Resistance Levels

Fibonacci ratios may be subjective but despite that they may still be used to identify key support or resistance levels.

One way to use these Fibonacci levels is to look for possible support and resistance levels and check if those levels are in line with the Fibonacci ones.

If such levels are found then the likelihood of the stock’s price bouncing off them will be higher.

Entry and Exit Points

So going off by what we said earlier about using the Fibonacci Retracement levels to identify key support and resistance levels in that once those levels have been found you may use them as potential entry and exit signals.

Like on some chart the key Fibonacci levels that are known to be areas of resistance or support may be 61.8% and 38.2% and if other traders are using those same support or resistance levels then theres a good chance of there being quite a number of trades around the levels.

Setting Stop-Loss Levels

Fibonacci retracements may even be used to determine stop loss levels so for example imagine you as a trader seeing a stock going higher.

Following a move up you see it retracing to 61.8% and after that it bounces up and goes high again.

Because this bounce happened at a Fibonacci level amidst an uptrend you find yourself deciding to buy and then setting a stop loss at that exact 61.8% level since a move below that may indicate that that rally has ultimately failed.

This is just one way you can go about setting up stop loss orders using this indicator.

Combining Fibonacci with Other Indicators

Sometimes using one indicator isn’t enough and you want to improve the accuracy of the indicator you’re currently using so that you can avoid those false signals.

The best way to do that with the Fibonacci Retracement levels is to combine it with other indicators and see how it relates to them, indicators like the RSI or the MACD for example.

Fibonacci Retracement Strategies for Different Trading Styles

You must have had a fair idea of what to do with this indicator by now but what about its relation to the popular trading styles like day, swing and long term trading? 

And how can you benefit your existing trading style by incorporating this indicator? Well let’s find that out then.

Day Trading with Fibonacci Retracement

Day, swing or long term trading with the Fibonacci Retracement levels has all to do with how far you’re looking back with those charts or what lookback period you want to use.

With day trading the focus generally tends to be on short term gains so employing a shorter time frame would be appropriate along with strategies that involve scalping and following trends.

Swing Trading with Fibonacci Retracement

As for swing traders whose focus lies primarily on medium to long term gains what they could do is apply a look back period that reflects their requirements.

And with that added time they could find themselves benefiting more from crossover strategies or reversals.

Long-Term Investing with Fibonacci Retracement

But what if it’s the long term that has you find appealing well then like with the day and swing traders you can adjust those time frames for a much longer look back into your stock’s historical prices.

By doing that you may find key areas of support and resistance and if they align with the Fibonacci levels then all the better.

Advantages and Limitations of Fibonacci Retracement

Like with any indicator there are both pros and cons to the Fibonacci Retracement levels and knowing both will go a long way  in you making the most out of your trading endeavors.

Benefits of Using Fibonacci Retracement

Let’s start with those benefits now. The tool can be good for determining key support and resistance levels or pivot points. It can be used with any time frame making it flexible and can be a decent display of market psychology

Limitations of Fibonacci Retracement

While those retracement levels may show you where the price might discover resistance or support there aren’t any assurances that the price would actually stop there which is why you have  other confirmation signals being used.

The other thing is that there tend to be so many of these retracement levels that the price may be likely to reverse near one or two of them very often and the problem with that is that a traders might struggle to know which of these levels will be worth it at any given time.

And if it doesn’t work then its often said that the trader just should have looked at another level instead.

Conclusion

Fibonacci Retracements can be a useful tool in your arsenal in identifying potential support and resistance levels and once you’ve found what you need you can place all kinds of orders like stop losses and set various price targets.

But one thing you have to keep in mind is that it’s not a one size fits all solution so you have to be aware of its limitations and ways to mitigate or trade around them.