What is a Fibonacci Retracement?
As Fibonacci’s famous numbers are expressed in nature very often, traders commonly believe that they influence the financial market as well. One widely employed trading tool among experienced investors is a Fibonacci retracement. A Fibonacci retracement is a series of horizontal lines on a stock chart conceived using the ratios from the numbers in the Fibonacci sequence. This trading tool works for some people but can easily backfire for others, so proceed with caution.
What are the key Fibonacci Ratios?
Before we address how the trading tool of Fibonacci retracement works, we need to understand what the Fibonacci ratios are and how they arise from the Fibonacci sequence. The Fibonacci sequence is a series of numbers where each number is simply the addition of the two numbers preceding it. The sequence goes on indefinitely as follows- ‘1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144…’ and so on.
The Fibonacci Ratios are 61.8%, 38.2%, and 23.6%. Here’s how they were arrived at. The first Fibonacci ratio -61.8%- can be formed by diving any one number in the sequence with the immediate number that succeeds it. For example, in the sequence, 21 is followed by 34. When 21is divided by 34 we get 0.6176. Additionally, 55 is followed by 89 and when it is divided by 89 we get 0.6179. Both these numbers can be rounded off to 0.618.
The Fibonacci ratio of 38.2%- is achieved by dividing a selected number by the number that is two spaces to its right in the sequence. So if we select 55, 144 is two numbers to its right, and the division of the two yields 0.3819, rounded off to 0.382. Finally, the ratio ‘23.6%’ is achieved by dividing any number from the sequence by the number three spaces to its right. When 8 divided by 34 which is three spaces on its right, it yields 0.2352.
What is Fibonacci Retracement used for?
A Fibonacci retracement is used to recognize key support or resistance levels in a stock’s performance by using Fibonacci ratios. In descending order, these ratios are 100%, 61.8%, 38.2%, and 23.6%. While 100% and 50% are not Fibonacci ratios, they are also used to create the retracement.
Each horizontal line (or level of retracement) is associated with a particular ratio or percentage. The percentage indicates how much of its prior movement the share has retraced. For instance, if the price of a stock first rises by ₹10, and then drops ₹2.36, it has retraced its prior movement by 23.6%, which is one of the Fibonacci ratios.
How is Fibonacci Retracement Created?
- To create a Fibonacci retracement, two extreme points on a stock chart -typically a peak and a trough- are randomly chosen.
- The Fibonacci indicator then connects these two high and low points that have been perceived as relevant by the trader.
- After two extremes are selected, the vertical distance between these two is calculated.
- This distance is then divided by key ratios: 100%, 61.8%,50%, 38.2%, and 23.6%.
- Using the final values, horizontal lines are drawn across the trendline, where each line coincides with each ratio.
- These lines can now be employed to identify potential resistance and support levels.
How Fibonacci Retracement is Used in Trading
While it is a high-risk trading tool, Fibonacci retracement can tell you when to enter or exit a trade. The levels traced can become your entry or exit points as these are where the activity of the stock is expected to change direction. Hence those who trade using Fibonacci ratios would prefer to place their entry or exit when the stock’s performance is at a key Fibonacci ratio. Those employing Fibonacci retracement will expect volatility around this time, which could work in their favor.
To know when to enter a trade, first, find a strong uptrend. This is defined as a stock with successive periods of highs with less than 50% ‘pullbacks’, otherwise known as moderate drops in performance. One this uptrend is identified, create your Fibonacci retracement, or find an indicator that will simulate the retracement for two high and low points of your choosing. Now observe how the stock is behaving around the key Fibonacci ratios of 38.2% and 50% since the morning highs.
To do so, look at the sales made and the time when the performance was at these levels. Most trades’ performance drops moderately (pullback) at the Fibonacci points but then continues to rise, sometimes even more than the previous high. Once you see the trading activity beginning to slow down at the Fibonacci ratio, you can enter the trade as investors might be selling it for a lower price. Based on the previous performance, this pullback will see a steep upward rise at some key points. You can use the most recent high as a point of exit. This way you can sell your trade for a higher cost than you bought it for and earn a profit.