Fibonacci retracement, part of the set of technical analysis tools based on the Fibonacci sequence, is a method used to identify possible support and resistance levels for a specific trading instrument. The concept behind the Fibonacci retracement is that markets tend to react (retrace) by predictable portions of a larger move. In a sense, Fibonacci retracements follow a series of continuation patterns.
Renowned Princeton economist and statistician Burton Malkiel first wrote about the use of the Fibonacci sequence in trading in "A Random Walk Down Wall Street." Malkiel argued that most price movements are random, but some natural reaction against a large price movement occurs as traders become hesitant or look to capture their gains. The degree of the retracement can then be estimated based on the vertical length of the security's support and resistance levels.
Traders who rely on Fibonacci retracement use the key Fibonacci ratios (23.6%, 38.2%, 50%, 61.8% and 100%) to place target prices or stop losses. There are also several crossovers and parallels between the use of Fibonacci analysis and Elliott wave theory.
The Fibonacci numbers have an uncommon application in the stock market, just as they do with nature as a whole. The rationale behind their use in trading is partially based on empirical evidence and partially on blind faith in the numbers. Traders believe that the depth of continuation patterns can be measured through this system. Countertraders can use this method to place target prices within their strategies.
One theory that has been offered about the usefulness of Fibonacci retracement is that markets are just as subject to certain natural laws as are the humans that guide them. Therefore, Fibonacci numbers should apply to financial markets. Indeed, Fibonacci retracement trading can be seen in stocks, commodities, forex markets and several other financial instruments.