Fibonacci retracements are popular among technical traders. They are 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 peak and a 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%.
- Fibonacci retracements are popular tools that traders can use to draw support lines, identify resistance levels, place stop-loss orders, and set target prices.
- A Fibonacci retracement is created by taking two extreme points on a stock chart and dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100%.
- Fibonacci retracements suffer from the same drawbacks as other universal trading tools, so they are best used in conjunction with other indicators.
How Fibonacci Ratios Work
Before we can understand why these ratios were chosen, let's review the Fibonacci number series.
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 ratios used by technical traders to determine retracement levels.
The key Fibonacci ratio of 61.8% 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 about 0.61798.
The 38.2% ratio is discovered by dividing a number in the series by the number located two spots to the right. For instance, 55 divided by 144 equals approximately 0.38194.
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 about 0.23529.
Fibonacci Retracement and Predicting Stock Prices
For unknown reasons, these Fibonacci ratios seem to play a role in the stock market, just as they do in nature. Technical traders attempt to use them to determine critical points where an asset's price momentum is likely to reverse.
Fibonacci retracements are the most widely used of all the Fibonacci trading tools. That is partly because of their relative simplicity and partly due to their applicability to almost any trading instrument. They can be used to draw support lines, identify resistance levels, place stop-loss orders, and set target prices. Fibonacci ratios can even act as a primary mechanism in a countertrend trading strategy.
Fibonacci retracement levels are horizontal lines that indicate the possible locations of support and resistance levels. Each level is associated with one of the above ratios or percentages. It shows how much of a prior move the price has retraced. The direction of the previous trend is likely to continue. However, the price of the asset usually retraces to one of the ratios listed above before that happens.
The following chart illustrates how a Fibonacci retracement appears. 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 and resistance levels.
In addition to the ratios described above, many traders also like using the 50% level.
The 50% retracement level is not really a Fibonacci ratio. However, traders often use it because of the tendency of asset prices to continue in a particular direction after a 50% retracement.
Fibonacci Retracement Pros and Cons
Despite the popularity of Fibonacci retracements, the tools have some conceptual and technical disadvantages that traders should be aware of when using them.
The use of the Fibonacci retracement is subjective. Traders may use this technical indicator in different ways. Those traders who make profits using Fibonacci retracement verify its effectiveness. At the same time, those who lose money say it is unreliable. Others argue that technical analysis is a case of a self-fulfilling prophecy. If traders are all watching and using the same Fibonacci ratios or other technical indicators, the price action may reflect that fact.
The underlying principle of any Fibonacci tool is a numerical 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 process. That does not make Fibonacci trading inherently unreliable. However, it can be uncomfortable for traders who want to understand the rationale behind a 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.
The Bottom Line
Fibonacci trading tools suffer from the same problems as other universal trading strategies, such as the Elliott Wave theory. That said, many traders find success using Fibonacci ratios and retracements to place transactions within long-term price trends.
Fibonacci retracement can become even more powerful when used in conjunction with other indicators or technical signals. Investopedia Academy's Technical Analysis course covers these indicators as well as how to transform patterns into actionable trading plans.