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The Fibonacci retracement is a type of technical analysis identifying where support and resistance levels are likely to occur. Each level is associated with a percentage, with the Fibonacci levels being 23.6%, 38.2%, 61.8%, and 78.6%. Although not technically a Fibonacci ratio, 50% is also used as well.
This indicator is useful for traders because it can connect two points that any trader views as relevant – usually a high and a low point. This means it can help traders decide when to open and close a trading position, or when to apply certain limits and stops to their trades.
The Fibonacci retracement levels are based on the mathematical principle of the golden ratio. The sequence for the golden ratio is 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89 and so on. Each number is around 1.618 times greater than the previous number.
To calculate the Fibonacci retracement levels, divide the number in the sequence by the number immediately following it. For example, 34 divided by 55 is roughly 0.618, which gives it the 61.8% Fibonacci retracement level.
When used correctly, Fibonacci retracements can be used to identify and place entry orders, stop-loss levels, or even set price targets. For instance, if a trader sees a stock moving up, then retraces to the 61.8% level, and then moves up again, the trader may decide to buy since this bounce occurred during an uptrend. The trader may even set a stop-loss at then 61.8% level, because a return lower than this level would indicate that the trade has failed.
Fibonacci retracement levels also show up in other technical analysis tools. For instance, they are seen in Gartley patterns and the Eliott Wave Theory.
Fibonacci retracement levels are static, unlike moving averages. This means it allows for easy and quick identification. The static nature of these levels also helps traders to anticipate and react when price levels are tested.
Although the retracement levels indicate where the price may find support or resistance, it does not indicate that the price will actually stop there. As such, other confirmation signals are used in tandem.
The technique also takes time to understand before it can be used effectively. Simply drawing lines will not yield a positive result unless the traders know exactly what they are doing.
Another argument is that there are so many levels that the price is likely to reverse near one of them, and quite often. A major problem is that traders often struggle to know which level will be useful at any given time instead.
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