What is Fibonacci retracement, and where do the ratios that are used come from?


Fibonacci levels is a popular tool among technical traders and is based on the key numbers identified by mathematician Leonardo Fibonacci in the 13th century. The Fibonacci number is not as important as the mathematical relationships, expressed as relations between numbers in the series.

In technical analysis Fibonacci retracement is created by taking two extreme points (usually the major peak and trough) on a stock chart, and the vertical distance is divided by key Fibonacci ratios 23.6%, 38.2%, 50%, 61.8% 100%. Once these levels are identified, horizontal lines and is used to determine possible levels of support and resistance. Before we can understand why these ratios were chosen, we should have a better understanding of the Fibonacci number series. (For a more in-depth discussion of this issue, see Golden section and Fibonacci.)

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The Fibonacci sequence looks like the following: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. Each term in this sequence is simply the sum of the two preceding terms and sequence continues infinitely. One of the remarkable characteristics of this numerical sequence is that each number is approximately 1.618 times the previous number. This common relationship between every number in the series is the Foundation of the common ratios used in retracement studies.

The key Fibonacci ratio of 61.8%, which is also known as the “Golden section” or “Golden mean” – is found by dividing one number in the series by the number that follows it. For example, 21 divided into 34 equal to 0.6176 and 55 divided by 89 equals 0.6179.

The ratio of 38.2% is found by dividing one number in the series by the number that is found two places to the right. For example, 55 divided by 144 is equal to 0.3819.

The ratio of 23.6% is found by dividing one number in the series by the number that is three places to the right. For example, 8 divided by 34 is equal to 0.2352.

For unknown reasons, these relationships play an important role in the stock market, as well as in nature, and can be used to determine critical points that cause the asset price in the reverse order. The direction of the prior trend is likely to continue once the price of the asset to be traced to one of the factors listed above.

The following Chart illustrates how Fibonacci can be used. Most modern trading platforms contain a tool that automatically draws in horizontal lines. Please note, as the price changes its direction as it approaches the levels of support/resistance.

In addition to the above-described ratios, many traders also like using the 50% and level 78.6%. 50% retracement is not a Fibonacci ratio, but is used because of the overwhelming trend of an asset in a particular direction after completing a 50% retracement.

How reliable is Fibonacci in predicting stock behavior?

Fibonacci is the most widely used of all trading tools the Fibonacci tool. This is partly due to their relative simplicity and partially due to their applicability to virtually any trading instrument. They can be used to identify and confirm the levels of support and resistance to place your stop loss and target prices, and even act as your primary mechanism in trading strategies against the trend. However, there are some conceptual and technical shortcomings that traders should know when using Fibonacci.

The use of the Fibonacci retracement is subjective. Different traders may use this technical indicator in different directions. Those traders who are profitable to use Fibonacci to test its effectiveness; those who loses money, say it is unreliable. Some argue that technical analysis is the case of self-fulfilling prophecy. If traders are watching and using the same levels or technical indicators, price action may reflect this fact.

A fundamental principle of any Fibonacci tool are numerical anomalies that are not based on any logical proof. Proportion, integers, sequences and formulas derived from the Fibonacci sequence not only a mathematical product of the violation. It is, in fact, wrong, but it may be inconvenient for traders who want to understand the rationale of the trading strategy.

In addition, the Fibonacci strategy can only point to the ability to correct, reverse, and bounces rear. This system is struggling to confirm any other indicators and provides easy to identify strong or weak signals. For this reason, Fibonacci requires other indicators or technical signals.

Trading Fibonacci tools suffer from the same problems as other flexible trading strategies, such as the theory of Elliott wave. Nevertheless, many traders find the use of a Fibonacci retracement and found success, using them to place trades during the greater price trends.

To learn more about the various tools used in technical analysis, see our technical analysis tutorial.

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