Fibonacci Retracement

5 mins read
by Angel One

Did you hate maths in school? Then you will be surprised to know that a mathematical series can help you plan a better trading strategy. In fact, technical trading, that is gaining so much mileage nowadays is based on principles of mathematics. Fibonacci series that you had learnt in your school is widely used by modern traders to plan trading strategy. How? We will discuss that in detail in this write-up.

Let’s see what a Fibonacci series looks like.

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89… and so on

Fibonacci series is a series of integers, where each increasing number of the series is the summation of the previous two numbers. The numbers of the series are denoted as Fn, where

F0 = 0 and F1= 1

and, the series is

Fn= Fn-2 + Fn-1

It has got its name after the famous Italian mathematician who invented it, who was also known as Leonardo Bigollo Pisano or Leonardo of Pisa.

The Fibonacci trading strategy is well known and practiced. And, if you are planning an entry into the equity market, you must learn about its concept too. So, how does this sequence come into play in the context of the stock market? But before we get into the part about Fibonacci in stock market, here are few interesting facts about it that will help you understand the whole subject better. When you divide any number in the sequence by its preceding number, the ratio you get is always 1.618. It is called the Golden Ratio. Similarly, any number of the series when divided by the succeeding one will give you the result 0.618, which in terms of percentage is 61.8 percent. That is not all. If a number in the sequence is divided by a number that is two spots higher, the result is around 0.382. For example, 13/34, 34/89 both result in the same fraction. This in percentage terms becomes 38.2 per cent. There is one more relevant percentage to remember. A number when divided by one more number that is three spots higher in the series results in 0.236. So, 13/55 or 21/89 are the same. This in percentage terms is 23.6 per cent. One thing you must notice that any ratio in Fibonacci series is always constant. Typically, Fibonacci ratios are 23.6, 38.2, 50,61.8 and 100 per cent.

So, what is the role of Fibonacci in stock market ? Fibonacci ratios are used in stock charts. Fibonacci retracement is a term commonly used in the stock chart context. It is created by choosing a trough and a peak and dividing the vertical distance by the Fibonacci ratios. Fibonacci retracement is a technical analysis method often used to find out support and resistance levels. To put it more clearly, these retracement levels are actually horizontal lines which give you an indication of where support and resistance could possibly occur. Before we discuss further the role Fibonacci play in stocks, let’s elaborate about support and resistance. Resistance level refers to a point at which an asset’s price won’t go up any further. Support lies on the other side of the spectrum, means it is the point at which the downward journey of a stock’s price hits pause and won’t decline further. Now let’s understand it in context with Fibonacci. If a trend is going up, the retracement lines drop from 100 to 0 per cent. If the trend is dropping the retracement lines will increase from 0 to 100 percent. The horizontal lines are drawn at the Fibonacci levels such as 38, 50 and 62 per cent. Support and resistance happen near or at the Fibonacci retracement levels.

This brings us to the discussion of pullback and impulse in the context of Fibonacci in stock market. What are these? Moves that are in the direction of a trend are known as impulses. Conversely,  those that go against the trend are known in technical analysis as pullbacks. Fibonacci retracements are usually used to decide on entering a certain trade while extensions may be used to know when to take profit or see to what extent a price can move one a pullback or retracement is done. Retracements are used to measure pullback in a trend, while extensions measure impulse waves.

Does it mean that Fibonacci retracement provides you with the exact entry point? The answer is, no. You have to keep that in mind while planning a trading strategy. It is just an estimated zone, not the precise point. Like any technical tool, you can’t use the Fibonacci trading strategy as a standalone tool. You would need to use it alongside other chart patterns to make the most out of them. Fibonacci is used in stock trading because of its unique features. It helps you understand more about market volatility and its extent so that you can decide on the right point to enter or exit the market. But results of Fibonacci must be asserted by the other charts used to plan your moves precisely.