Loading the player...
A:

Fibonacci retracement is a popular tool among technical traders and is based on the key numbers identified by mathematician Leonardo Fibonacci in the 13th century. Fibonacci's sequence of numbers is not as important as the mathematical relationships, expressed as ratios, between the numbers in the series.

In technical analysis, a Fibonacci retracement is created by taking two extreme points (usually a major peak and trough) on a stock chart and dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance levels. Before we can understand why these ratios were chosen, we need to have a better understanding of the Fibonacci number series. (For a more in-depth discussion of this subject, see Fibonacci and the Golden Ratio.)

[Fibonacci retracement is a popular technical indicator that can become even more powerful when used in conjunction with other indicators. If you want to learn more about this, as well as how to transform patterns into actionable trading plans, Investopedia Academy's technical analysis course is a great start.]

The Fibonacci sequence of numbers is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. Each term in this sequence is simply the sum of the two preceding terms, and the sequence continues infinitely. One of the remarkable characteristics of this numerical sequence is that each number is approximately 1.618 times greater than the preceding number. This common relationship between every number in the series is the foundation of the common ratios used in retracement studies.

The key Fibonacci ratio of 61.8% - also referred to as "the golden ratio" or "the golden mean" - is found by dividing one number in the series by the number that follows it. For example, 21 divided by 34 equals 0.6176 and 55 divided by 89 equals 0.6179.

The 38.2% ratio is found by dividing one number in the series by the number that is found two places to the right. For example, 55 divided by 144 equals 0.3819.

The 23.6% ratio is found by dividing one number in the series by the number that is three places to the right. For example, 8 divided by 34 equals 0.2352.

For reasons that are unclear, these ratios seem to play an important role in the stock market, just as they do in nature, and can be used to determine critical points that cause an asset's price to reverse. The direction of the prior trend is likely to continue once the price of the asset has retraced to one of the ratios listed above.

The following chart illustrates how Fibonacci retracement can be used. Most modern trading platforms contain a tool that automatically draws in the horizontal lines. Notice how the price changes direction as it approaches the support/resistance levels.

FibRetracement.gif

In addition to the ratios described above, many traders also like using the 50% and 78.6% levels. The 50% retracement level is not really a Fibonacci ratio, but it is used because of the overwhelming tendency for an asset to continue in a certain direction once it completes a 50% retracement.

How reliable is the Fibonacci retracement in predicting stock behavior?

Fibonacci retracements are the most widely used of all the Fibonacci trading tools. This is partially due to their relative simplicity and partially due to their applicability to almost any trading instrument. They can be used to identify and confirm support and resistance levels, place stop-loss orders or target prices, and even act as a primary mechanism in a countertrend trading strategy. However, there are some conceptual and technical disadvantages that traders should be aware of when using a Fibonacci retracement.

The use of the Fibonacci retracement is subjective. Different traders may use this technical indicator in different ways. Those traders who are profitable using the Fibonacci retracement verify its effectiveness; those who lose money say it is unreliable. Some argue technical analysis is a case of a self-fulfilling prophecy. If traders are all watching and using the same levels or technical indicators, the price action may reflect that fact. 

The underlying principle of any Fibonacci tool is a numeric anomaly that is not grounded in any logical proof. The ratios, integers, sequences and formulas derived from the Fibonacci sequence are only the product of a mathematical irregularity. This is not inherently wrong, but it is can be uncomfortable for traders who want to understand the rationale behind a trading strategy.

Furthermore, a Fibonacci retracement strategy can only point to possible corrections, reversals and countertrend bounces. This system struggles to confirm any other indicators and doesn't provide easily identifiable strong or weak signals. For this reason, the Fibonacci retracement requires other indicators or technical signals.

Fibonacci trading tools suffer from the same problems as other universal trading strategies, such as the Elliott wave theory. That said, many traders find uses for Fibonacci retracements and have found success using them to place transactions within greater price trends.

To learn more about the various tools used in technical analysis, see our Technical Analysis tutorial.

RELATED FAQS
  1. What are some of the more common Fibonacci retracements?

    Examine the basic Fibonacci retracement levels, and learn how key Fibonacci levels are used by traders to identify potential ... Read Answer >>
  2. Why is the Fibonacci Retracement important for traders and analysts?

    Find out why traders and analysts in financial markets use Fibonacci retracement to help identify support and resistance ... Read Answer >>
  3. How can a swing trader use a Fibonacci retracement?

    Learn how swing traders can use Fibonacci retracements to identify areas of support and resistance, as well as entry and ... Read Answer >>
  4. What are the most common strategies to place retracement levels?

    Find out how traders place Fibonacci retracement levels, and learn what it means when a price retracement seems to reverse ... Read Answer >>
  5. Why are Fibonacci Clusters important in a Fibonacci Retracement Strategy?

    Find out how Fibonacci clusters form and how they can be used by traders and analysts to identify support and resistance ... Read Answer >>
  6. What are the main differences between a PHI-Ellipse and a Fibonacci Retracement?

    Discover the unique technical indicator known as the PHI-ellipse and learn how it differs as a trading tool from Fibonacci ... Read Answer >>
Related Articles
  1. Investing

    Taking The Magic Out Of Fibonacci Numbers

    Uncover the history and logic behind this popular trading tool.
  2. Investing

    How to Use Fibonacci to Find Profitable Trades

    Use these two original Fibonacci techniques to pinpoint the patterns in stock movements, and the most reliable entry and exit levels.
  3. Trading

    Advanced Fibonacci Applications

    Extensions, clusters, channels and more! Discover new ways to put the 'golden ratio' to work.
  4. Investing

    Using Fibonacci to Analyze Gold (GLD, GC)

    Use Fibonacci studies to analyze gold by picking out hidden harmonic levels that can provide major support or resistance.
  5. Trading

    Stocks Trading at the 61.8% Pullback Level (TSLA,NAVI)

    Here are stocks trading the 61.8% Fibonacci retracement level, and how to trade them (and this recurring pattern).
  6. Trading

    3 Fibonacci Trades For Late Summer

    Fibonacci retracement analysis organizes chaotic price action, highlighting hidden buying and selling opportunities.
  7. Trading

    What You Can Learn From the Latest Bitcoin Panic

    This is not the first time the price of Bitcoin has tanked.
  8. Trading

    Retracement or Reversal: Know the Difference

    Learn to distinguish between a temporary price change and a long-term trend.
  9. Trading

    How to Calculate Bitcoin's Next Price Move

    Technical analysis can offer a roadmap to where Bitcoin prices are headed next.
  10. Trading

    Here's Where Roku Stock Could Go Next

    After a hot IPO, Roku stock is testing some key levels.
RELATED TERMS
  1. Fibonacci Fan

    A charting technique consisting of three diagonal lines that ...
  2. Fibonacci Arc

    A charting technique consisting of three curved lines that are ...
  3. Gartley Pattern

    The Gartley pattern is a complex chart pattern, based on Fibonacci ...
  4. Tirone Levels

    A series of three sequentially higher horizontal lines used to ...
  5. Technical Analysis

    A method of evaluating securities by analyzing statistics generated ...
  6. Bullish Abandoned Baby

    The bullish abandoned baby is a type of candlestick pattern that ...
Hot Definitions
  1. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  2. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  3. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  4. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  5. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
  6. Price Elasticity of Demand

    Price elasticity of demand is a measure of the change in the quantity demanded or purchased of a product in relation to its ...
Trading Center