What is a Fibonacci Retracement?
A Fibonacci retracement is a term used in technical analysis that refers to areas of support or resistance. Fibonacci retracement levels use horizontal lines to indicate where possible support and resistance levels are. Each level is associated with a percentage. The percentage is how much of a prior move the price has retraced. The Fibonacci retracement levels are 23.6%, 38.2%, 61.8% and 78.6%. While not officially a Fibonacci ratio, 50% is also used.
The indicator is useful because it can be drawn between any two significant price points, such as a high and a low, and then the indicator will create the levels between those two points.
If the price rises $10, and then drops $2.36, it has retraced 23.6%, which is a Fibonacci number. Fibonacci numbers are found throughout nature, and therefore many traders believe that these numbers also have relevance in the financial markets.
- The indicator connects any two points that the trader views at relevant, typically a high and low point.
- Once the indicator has been drawn on the chart, the levels are fixed and will not change. The percentage levels provided are areas where the price could stall or reverse.
- Levels should not be relied on exclusively. For example, it is dangerous to assume the price will reverse after hitting a specific Fibonacci level. It may, but it also may not.
- Fibonacci retracement levels are most frequently used to provide potential areas of interest. If a trader wants to buy, they watch for the price to stall at a Fibonacci level and then bounce off that level before buying.
- The most commonly used ratios include 23.6%, 38.2%, 50%, 61.8% and 78.6%. These represent how much of a prior move the price has corrected or retraced.
The Formulas for Fibonacci Retracement Levels Are:
The indicator itself doesn't have any formulas. When the indicator is applied to a chart the user chooses two points. Once those two points are chosen, the lines are drawn at percentages of that move.
If the price rises from $10 to $15, and these two prices levels are the points used to draw the retracement indicator, then 23.6% level will be at $13.82 ($15 - ($5 x 0.236)) = $13.82. The 50% level will be at $12.50 ($15 - ($5 x 0.5)) = $12.50.
How to Calculate Fibonacci Retracement Levels
As discussed above, there is nothing to calculate when it comes to Fibonacci retracement levels. They are simply percentages of whatever price range is chosen.
You may wonder where these numbers come from, though. They are based on something called the Golden Ratio.
If you start a sequence of numbers with zero and one, and then keep adding the prior two numbers, you end up with a number string like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987...with the string continuing on indefinitely.
The Fibonacci retracement levels are all derived from this number string. Excluding the first few numbers, as the sequence gets going, if you divide one number by the next number you get 0.618, or 61.8%. Divide a number by the second number to its right and you get 0.382 or 38.2%. All the ratios, except for 50% since it is not an official Fibonacci number, are based on some mathematical calculation involving this number string.
Interestingly, the Golden Ratio of 0.618 or 1.618 is found in sunflowers, galaxy formations, shells, historical artifacts and architecture.
What Do Fibonacci Retracement Levels Tell You?
Fibonacci retracements can be used to place entry orders, determine stop loss levels, or set price targets. For example, a trader may see a stock moving higher. After a move up it retraces to the 61.8%% level, and then starts to bounce again. Since the bounce occurred at a Fibonacci level, and the longer trend is up, the trader decides to buy. They could set a stop loss at the 78.6% level, or the 100% level (where the move started).
Fibonacci levels are used in other forms technical analysis as well. For example, they are prevalent in Gartley patterns and Elliott Wave theory. After a significant price movement up or down, when the price retraces (which it always does), these forms of technical analysis find the retracements will tend to reverse near certain Fibonacci levels.
Fibonacci retracement levels are static prices that do not change, unlike moving averages. The static nature of the price levels allows for quick and easy identification. This allows traders and investors to anticipate and react prudently when the price levels are tested. These levels are inflection points where some type of price action is expected, either a rejection or a break.
The Difference Between Fibonacci Retracements and Fibonacci Extensions
While Fibonacci retracements apply percentages to a pullback, Fibonacci extensions apply percentages to a move back in the trending direction. For example, a stock goes from $5 to $10, and then back to $7.50. The move from $10 to $7.50 is a retracement. If the price starts rallying again and goes to $16, that is an extension.
Limitations of Using Fibonacci Retracement Levels
While the retracement levels indicate where the price could potentially find support or resistance, there are no assurances the price will actually stop there. This is why other confirmation signals are often used, such as the price actually starting to bounce off the level.
The other argument against Fibonacci retracement levels is that there are so many of them that the price is likely to reverse near one of them quite often. The problem is that in advance traders struggle to know which one will be useful on the current retracement they are analyzing.