A Fibonacci retracement is a popular tool among technical traders. It 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.
- A Fibonacci retracement is a popular tool that traders can use to identify support and resistance levels, and place stop-loss orders or 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 the Fibonacci Sequence Works
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 common ratios used in retracement studies.
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 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.
Fibonacci Retracement and Predicting Stock Prices
For reasons that are unclear, these Fibonacci 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.
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.
Fibonacci retracement levels use horizontal lines to indicate where possible support and resistance levels are. Each level is associated with one of the above ratios or percentages, indicating the percentage is how much of a prior move the price has retraced. 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 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/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, but traders often like it because of the overwhelming tendency for an asset to continue in a certain direction once it completes 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. 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 the same 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 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.
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 uses for Fibonacci retracements and have found success using them to place transactions within greater 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.