Fibonacci retracements are a common tool among traders and are based on the Fibonacci series identified in the 13th century by the famous Leonardo Fibonacci. The Fibonacci sequence is a set of numbers that is also related to nature, and also called the golden ratio.
A Fibonacci retracement tool is used by technical analysts as a guide to the behavior of the market. Traders use the tool for identification of resistance levels, drawing support lines setting target prices, and placing stop-loss orders.
During a technical analysis, Fibonacci retracement is done by picking a different extreme point on the stock chart, mostly peak and trough. The vertical distance is then divided by the Fibonacci ratios, i.e., 23.6%, 38.2%, 50%, 61,8% and 100%. After identifying the levels, a horizontal line is drawn and identifies the hypothetical resistance and support levels.
How the Fibonacci Ratio Works
The Fibonacci series is: 0,1,1,2,3,5,8,13,21,34,55, etc. Each term in the series is a sum of the preceding terms, and the sequence goes on to infinity. One characteristic of the Fibonacci sequence is that every number in the series is approximately 1.618 times greater than the previous number. This is the very foundation of the ratio’s traders use to work out the retracement level.
The key ratio of 61.8% is derived by the division of one number in the sequence, by the number following it. For instance, 21 divided by 34= 0.6176, 55 divided by 89= 0.61798. The 38.2% is arrived at by dividing one number in the sequence by the number falling two places to its right.
For example, 55 divided by 144= around 0.38194. The 23,6% ratio is arrived at by dividing one number in the sequence, by the number three spots to its right. The 23.6% ratio is arrived at by dividing one number in the sequence by a number three spots to its right. For instance, 8/32= approximately 0.23529.
Fibonacci Retracing and How it Predicts Stock Prices
For some reason, the Fibonacci ratios work in the stock market as they work in nature. Traders try to use them for the determination of crucial points where the price momentum of an asset is likely to go backward.
Fibonacci retracements are the most common of the Fibonacci trading tools. This is because of their simplicity in part, and because they apply to almost all trading tools. They are used as primary mechanisms in countertrend trading strategies.
Fibonacci retracement levels are horizontal lines, which show the hypothetical support and resistance levels. Every level is related to one of the percentages or ratios. It indicates how much or the previous move the price retraces, with the previous trend’s direction likely to go on. The asset price normally retraces to one of the ratios before this happens.
Pros and Cons of the Fibonacci Retracement
As popular as the Fibonacci retracements are, these tools have some disadvantages.
- Using the Fibonacci retracement tool is subjective, and can be used in different ways. Some people who make money using it swear on its effectiveness, while those who make losses swear on its unreliability.
- Some traders consider the Fibonacci retracement as an illusion. Since the tool is repeatedly used by most traders, they often get similar results every time. This means that orders are stuck at similar price levels, which pushes the price in the direction they want.
- To use the Fibonacci tool, you have to have an in-depth understanding of the tool. Lines drawn on price charts at the percentages will not give you results unless you know what to look for. Beginner traders should be wary of using these tools and be sure that an asset price’s dip is temporary, not a permanent reversal.
A Fibonacci retracement is a powerful tool when used alongside other technical or indicator signals. The support and resistance levels are an indicator of potential rises or dips in market trends. This could show traders when it is lucrative to open or close positions. The Fibonacci retracement can be very useful and yield rewards for any trader who knows how to use the tool properly. Beginners are advised to approach the tool with caution or lose money while using the complex tool.