Fibonacci retracement

What Is Fibonacci Retracement?

Fibonacci retracement is a popular method within technical analysis used by traders and investors to identify potential areas of support and resistance in the price movements of financial assets. It is based on the idea that after a significant price move in one direction, the price will often retrace, or pull back, a predictable portion of the original move before continuing in the initial direction⁷⁴. This tool overlays horizontal lines on a price chart at specific percentages, derived from the mathematical relationships found in the Fibonacci sequence. These levels are watched closely as potential points where the price might pause, reverse, or accelerate, influencing decisions related to entry points and exit points⁷³.

History and Origin

The concept of Fibonacci retracement is rooted in the Fibonacci sequence, a series of numbers originally introduced to the Western world by the Italian mathematician Leonardo Pisano, better known as Fibonacci, in his 1202 book Liber Abaci (The Book of Calculation)⁷¹, ⁷². While the sequence had been known in ancient Indian mathematics centuries earlier, Fibonacci popularized it through practical illustrations, such as a problem involving rabbit breeding⁶⁸, ⁶⁹, ⁷⁰.

The sequence begins with 0 and 1, and each subsequent number is the sum of the two preceding ones (e.g., 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, and so on)⁶⁶, ⁶⁷. The remarkable property that underpins Fibonacci retracement lies in the ratios derived from this sequence. As the numbers progress, the ratio of any number to its succeeding number approaches approximately 0.618 (e.g., 34/55 ≈ 0.618), known as the Golden Ratio or Phi. Other significant ratios emerge when a number is divided by the number two places to its right (approximately 0.382) or three places to its right (approximately 0.236). ⁶³, ⁶⁴, ⁶⁵These mathematical relationships, observed widely in nature, art, and architecture, have also been applied to analyze patterns in financial markets. ⁶¹, ⁶²The belief is that these universal proportions may somehow resonate with collective market psychology, creating predictable turning points.

Key Takeaways

• Fibonacci retracement levels are horizontal lines on a price chart indicating potential areas of support and resistance.
• They are derived from the mathematical ratios (23.6%, 38.2%, 50%, 61.8%, 78.6%) of the Fibonacci sequence, which emerge from the Golden Ratio.
  ⁵⁹, ⁶⁰ Traders use these levels to anticipate price pullbacks within an existing trendline and identify possible areas for placing stop-loss orders or setting price targets.
  ⁵⁷, ⁵⁸ While widely used, Fibonacci retracements are often considered most effective when combined with other technical analysis tools and indicators.

⁵⁶## Formula and Calculation

Fibonacci retracement levels are not calculated using a single formula in the traditional sense, but rather by applying a set of fixed percentages to a defined price range. To determine these levels, traders first identify a significant price "swing high" and a "swing low" on a chart, representing the start and end of a notable price move.
⁵⁴, ⁵⁵
Once these two extreme points are established, the vertical distance between them is determined. Then, horizontal lines are drawn at specific percentages of this distance, measured from the swing high in a downtrend, or from the swing low in an uptrend:
⁵², ⁵³

• 23.6%
• 38.2%
• 50.0% (While not a true Fibonacci ratio, it is widely used due to its significance as a midpoint)
  *⁴⁹, ⁵⁰, ⁵¹ 61.8% (The Golden Ratio)
• 78.6% (Sometimes 76.4% or square root of 61.8%)

⁴⁶, ⁴⁷, ⁴⁸For an uptrend (price moves from low to high):

For a downtrend (price moves from high to low):

Most modern charting software automatically calculates and displays these levels once the user selects the swing high and swing low points.
⁴⁵

Interpreting the Fibonacci Retracement

Interpreting Fibonacci retracement levels involves understanding them as potential areas where price movement might react. These levels are viewed as dynamic areas of support and resistance rather than exact turning points.

In an uptrend, when a price pulls back, traders might look for buying opportunities near the Fibonacci retracement levels (e.g., 38.2%, 50%, or 61.8%). ⁴⁴The expectation is that the price will find support at one of these levels and then continue its upward movement. Conversely, in a downtrend, when the price experiences a bounce or rally, traders might look for selling opportunities near these same Fibonacci levels, expecting them to act as resistance before the price resumes its decline.
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The significance of each level can vary. A shallow retracement (e.g., 23.6% or 38.2%) might suggest a very strong underlying trend, while deeper retracements (e.g., 61.8% or 78.6%) could indicate a more significant correction or even a potential shift in the overall price action. However, the tool does not guarantee that prices will reverse precisely at these levels; rather, it highlights areas of interest where a reaction is more probable due to collective market observation.
⁴²

Hypothetical Example

Consider a hypothetical stock, "DiversiStock Inc.," that has been in a strong uptrend, moving from a low of $50 to a high of $100 over a period of weeks. A trader believes this stock might experience a temporary pullback before continuing its rally.

To apply Fibonacci retracement, the trader identifies the swing low at $50 and the swing high at $100. The total price range for this move is $100 - $50 = $50.

Using the Fibonacci ratios, the potential retracement levels are calculated as follows:

• 23.6% Retracement: $100 - ($50 × 0.236) = $100 - $11.80 = $88.20
• 38.2% Retracement: $100 - ($50 × 0.382) = $100 - $19.10 = $80.90
• 50.0% Retracement: $100 - ($50 × 0.500) = $100 - $25.00 = $75.00
• 61.8% Retracement: $100 - ($50 × 0.618) = $100 - $30.90 = $69.10

As DiversiStock Inc. begins to retrace, it might dip towards the $80.90 (38.2%) level. A trader, observing this, might consider placing a buy order at or near this entry point, anticipating that the stock will find support there and resume its upward trend. They might also place a stop-loss order below the next significant Fibonacci level, such as $69.10, to limit potential losses if the retracement goes deeper than expected.

Practical Applications

Fibonacci retracement is widely applied across various aspects of active trading and market analysis:

• Identifying Potential Reversal Points: Traders often use Fibonacci levels to pinpoint where a pullback within an existing trend might end, providing potential entry points or exit points. For example, in an uptrend, a price might retrace to the 61.8% level and then continue its ascent.
• ⁴¹Setting Stop-Loss Orders: Many traders place stop-loss orders just beyond a key Fibonacci level, assuming that if the price breaks decisively past that level, the anticipated retracement has failed or a trend reversal is underway.
• ³⁹, ⁴⁰Determining Price Targets: Beyond retracements, Fibonacci extensions (which project price movements beyond the original trend) use similar ratios to set profit targets for trades.
• ³⁸Confirmation with Other Indicators: Fibonacci retracement is rarely used in isolation. It is frequently combined with other technical analysis tools like moving averages, candlestick patterns, or volume indicators to confirm potential turning points. For ³⁶, ³⁷instance, a bullish engulfing candlestick pattern appearing at a 61.8% retracement level could be seen as a stronger buy signal. The Babypips.com article "How to Use Fibonacci Retracements" provides practical guidance on integrating this tool into trading practices.
• ³⁵Market Event Analysis: While not a direct predictor, these levels are sometimes observed in historical market events. For example, during the gold bull market from 2008–2011, Fibonacci retracement levels were reportedly useful in identifying temporary support levels during price declines before the rally resumed.

Li³⁴mitations and Criticisms

Despite its widespread popularity among technical analysts, Fibonacci retracement is not without limitations and criticisms. A primary critique is its subjectivity. The ac³³curacy of Fibonacci levels heavily depends on the "swing high" and "swing low" points chosen by the trader. Differ³²ent traders may select different points, leading to varied retracement levels and potentially conflicting interpretations. This s³¹ubjectivity can make it challenging to apply the tool consistently.

Another significant criticism is that Fibonacci retracement levels may act as a self-fulfilling prophecy. Becaus³⁰e so many traders utilize these levels, the collective buying or selling activity around these specific percentages can artificially create the very support and resistance levels that the tool purports to identify. If a c²⁸, ²⁹ritical mass of market participants reacts to these levels, it can create temporary price reactions, regardless of any inherent mathematical significance to market dynamics.

Furth²⁷ermore, Fibonacci retracements do not inherently possess predictive power on their own. They highlight potential areas of interest but do not guarantee that a price reversal will occur at any given level. Prices²⁶ can, and often do, move through these levels without reaction, especially in highly volatile or news-driven markets. Critic²⁵s argue that relying solely on Fibonacci retracements can lead to poor trading decisions and inadequate risk management. As And²³, ²⁴rew Thrasher, a Chartered Market Technician, highlights in "Should We Stop Using Fibonacci Retracements?", while the concept has existed for centuries, its application in financial markets does not always yield reliable support. Theref²²ore, it is generally advised that Fibonacci retracement be used in conjunction with other forms of technical analysis for confirmation.

Fi²⁰, ²¹bonacci Retracement vs. Elliott Wave Theory

Fibonacci retracement and Elliott Wave Theory are both methods of technical analysis that aim to forecast price movements, and they are often used in conjunction, yet they differ fundamentally in their approach.

Fibonacci retracement is a quantitative tool that focuses on identifying specific price levels (percentages of a prior move) where a market correction or pullback might end. It pro¹⁹vides static price levels for potential support and resistance. Its application is relatively straightforward: select a high and low point, and the tool generates the percentage-based retracement levels.

In co¹⁸ntrast, Elliott Wave Theory, developed by Ralph Nelson Elliott, is a more qualitative and interpretive framework that suggests market prices move in discernible, repetitive wave patterns, driven by collective market psychology. It pos¹⁶, ¹⁷its that markets unfold in a fractal nature, consisting of five waves in the direction of the main trend (motive waves) and three corrective waves against it. Elliot¹⁵t Wave Theory provides a structural roadmap of market trends and cycles, but it does not inherently offer precise price levels.

The r¹⁴elationship between the two lies in their complementary nature. Traders often use Fibonacci retracement levels to measure the probable depth of corrective waves or the projected length of impulse waves within the Elliott Wave structure. For ex¹², ¹³ample, an Elliott Wave analyst might expect a Wave 2 correction to retrace 50% or 61.8% of Wave 1, or a Wave 4 correction to retrace 38.2% of Wave 3. This i¹¹ntegration allows for more precise entry point and exit point identification within the broader Elliott Wave count.

FA¹⁰Qs

What are the main Fibonacci retracement levels?

The main Fibonacci retracement levels used in technical analysis are 23.6%, 38.2%, 50.0%, 61.8%, and 78.6%. The 50% level is included due to its historical significance in market behavior as a common midpoint for pullbacks, even though it is not directly derived from the Fibonacci sequence.

H⁸, ⁹ow accurate are Fibonacci retracements?

Fibonacci retracements are not considered predictive with absolute certainty. While they can highlight areas where price reactions might occur, there is no guarantee that the price will reverse precisely at these levels. Their ⁷effectiveness is often debated, with some attributing observed reactions to a self-fulfilling prophecy where widespread use by traders influences price. It is ⁶generally recommended to use them in conjunction with other technical analysis tools for greater accuracy and confirmation.

C⁵an Fibonacci retracements be used for all types of assets?

Yes, Fibonacci retracements can be applied to various financial markets, including stocks, foreign exchange (forex), commodities, and indices. The un³, ⁴derlying principle of identifying pullbacks within trends is universal, making the tool adaptable to different asset classes and timeframes.

What is the Golden Ratio in relation to Fibonacci retracement?

The Golden Ratio, approximately 1.618 (or its inverse, 0.618), is a mathematical constant found throughout nature and art. In the context of Fibonacci retracement, the 61.8% level is derived from this ratio (e.g., dividing any Fibonacci number by the number immediately following it, such as 34/55 ≈ 0.618). It is co²nsidered a particularly significant level in market psychology and is often watched as a strong potential point¹