Fibonacci Retracement Meaning
The Fibonacci retracement is a trading chart pattern that traders use to identify trading levels and the range at which an asset price will rebound or reverse. The reversal may be upward or downward and can be determined using the Fibonacci trading ratio.
Traders obtain the pattern by drawing horizontal lines for support and resistance levels and a potential trading price range for specific assets. It is a powerful tool for identifying bullish and bearish trends and placing entry orders accordingly to make profits. In simpler words, retracement is the difference between the high (peak) and low (trough) prices of an asset for the forecast period after applying Fibonacci percentages.
- Fibonacci retracement is a technical trading pattern that helps traders identify support and resistance levels at which the existing trend, whether upward or downward, will rebound or reverse.
- It uses the Fibonacci sequence of natural numbers (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, and 55 to infinity) to calculate these levels. The unique attributes of these numbers give retracement ratios (23.6%, 38.2%, 61.8%, and so on) that help predict retracement in the asset value.
- The Fibonacci retracement levels enable traders to decide on placing buy and sell orders and identify the two extreme points (peak and trough) for buying or selling assets to make more profits.
How Does Fibonacci Retracement Work?
In financial markets, fluctuation in asset prices is normal and occurs as impulses and pullbacks. Based on the direction of price movement, investors and traders can make profits or suffer losses. Therefore, they must rely on technical analysis and use related tools to their advantage. Fibonacci retracement strategy determines two price levels at which reversal of a pullback may happen. It is then quickly followed by retracement per the trending direction.
Retracement is a popular technical tool for investors to determine the Fibonacci levels, at which an uptrend or downtrend is likely to rebound or reverse. The retracement pattern is created using the Fibonacci numbers, introduced by Italy-based mathematician Leonardo Fibonacci in the 13th century.
Fibonacci numbers are nothing but a series of natural numbers, beginning with 0 and 1 and continuing infinitely. Each next number in the series is derived by adding two previous numbers. Hence, the numbers formed are:
0 + 1 = 1
1 + 1 = 2
1 + 2 = 3
2 + 3 =5
3 + 5 = 8
5 + 8 = 13
8 + 13 = 21
13 + 21 = 34
21 + 34 = 55
34 + 55 = 89
55 + 89 = 144, and the sequence extends to infinity.
It is also found that whenever any number in the series is divided by its immediate predecessor, the ratio obtained is the same, i.e., 1.618. This ratio is termed the Golden Ratio. For example:
55/34 = 1.618
89/55 = 1.618
144/89 = 1.6179 = 1.618
Fibonacci Ratios or Percentages
The pattern in these numbers, when computed further, gives a percentage called Fibonacci percentage. This time each number is divided by its succeeding numbers at first, second, and third positions. These Fibonacci trading percentages are used in the stock markets to predict support and resistance levels for the existing trend.
For example, when any number in the series is divided by its immediate successor, the ratio obtained is 0.618 (e.g., 89/144 = 0.618). Similarly, by dividing any number in the series by a number placed two places higher, the quotient obtained is 0.382 (e.g., 55/144 = 0.382). Likewise, when any number is divided by a number placed three places higher, the ratio is 0.236 (e.g., 34/144= 0.236).
Each ratio is an indicator of how strong would be the reverse momentum. In other words, the higher the percentage is, the longer would be the price reversal trend.
When written in percentage format, these quotients become 61.8%, 38.2%, 23.6%, and so on. These percentages determine the Fibonacci levels and help investors predict the reversal of the upward or downward trend. Traders often use the unofficial Fibonacci ratio of 50%, which is considered a part of Fibonacci retracement levels but comes from the Dow Theory.
How To Calculate Fibonacci Retracement Levels?
There is no specific formula to determine retracement levels. However, traders can draw them on a stock chart by identifying the trend and considering the potential price range (high or peak and low or trough) for a specific asset at support and resistance levels. In the next step, they need to calculate the difference between the two prices to find a target price. Lastly, they have to multiply the resultant with a Fibonacci ratio or percentage and subtract it from or add it to the high or low price, depending on the trend.
The most commonly used ratios include 23.6%, 38.2%, and 61.8%. Based on the price trends of an asset in the financial market, traders rely on the following formula to calculate Fibonacci levels:
Uptrend Retracement = High Swing – ((High Swing – Low Swing) × Fibonacci percentage)
Downtrend Retracement = Low Swing + ((High Swing – Low Swing) × Fibonacci percentage)
Let us consider two scenarios – uptrend and downtrend.
For example, assume an asset recording a high swing of $150.44 and a low swing of $140.56 in an uptrend. In that case, the uptrend and buy order would be:
$150.44 – $140.56 = $9.88
Hence, the uptrend retracement for the asset at the Fibonacci ratio 38.2% at the support level would be:
Uptrend Retracement = $150.44 – (($150.44 – $140.56) x 38.2%)
$150.44 – ($9.88 x 0.382)
$150.44 – $3.77
Similarly, if high swing for an asset in a downtrend is $160.76 and low swing is $154.64, the downtrend and sell order would be:
$160.76 – $154.64 = $6.12
Hence, the downtrend retracement for the asset at the Fibonacci ratio 61.8% at the resistance level would be:
Downtrend Retracement = $154.64 + (($160.76 – $154.64) x 61.8%)
$154.64 + ($6.12 x 0.618)
$154.64 + $3.78
The retracement for different Fibonacci percentages in both trends can be obtained in the same way.
Uses Of Fibonacci Retracement
Fibonacci retracement strategy is more common in the stock market, whether it is an uptrend or downtrend. The nature of financial markets is such that each tradable asset rebounds or reverses upon reaching a certain retracement level. It means there is a high probability of a stock regaining its peak or trough.
Let us say, if a stock price appreciates to $210 from $160, there is a strong possibility of it to retrace back to $185 before rising again to $225 (reversal). With that said, there are many ways of using retracement, such as:
- Identifying bullish and bearish market trends
- Estimating potential reversal levels (support and resistance)
- Setting target price and stop loss for an asset
- Placing buy or sell orders
It helps traders trade in the market when stocks rally sharply, and all they have to do is wait for retracement or correction to happen. After identifying Fibonacci levels (23.6%, 38.2%, and 61.8%), traders can decide whether to buy or sell that stock. For example, if a downtrend starts to go up, they can analyze the future market trend using the retracement level and decide when to sell an asset to get the best value.
In April 2021, the EUR/USD pair was discovered to have reached its all-time high. It was trading a bit more at 1.1976 than the moving averages and above the Fibonacci retracement level of 50%. The bulls calculated the retracement level at 61.8% and targeted it at 1.2040, causing the pair to rise in value further.
Also, it allows traders to identify bear traps and avoid being tricked by mature investors in the market. Overall, the Fibonacci retracement strategy prepares traders for the upcoming fluctuations in the market and allows them to trade safely in unpredictable market scenarios.
Frequently Asked Questions (FAQs)
Fibonacci retracement is a technical trading chart pattern, predicting levels at which reversal of a pullback may occur. It is then quickly followed by retracement per the trending direction.
To use the tool, one should first identify the market trend and determine a potential price range (peak and trough) of an asset at support and resistance levels. Next, they need to drag the point from high swing to low swing of the existing trend. Now, they can predict the uptrend or downtrend using Fibonacci trading ratios, i.e., 23.6%, 38.2%, and 61.8%.
To calculate retracement levels at which the existing uptrend or downtrend would rebound or retrace, one must find the difference between the selected highest and lowest prices. Next, they need to multiply the number obtained with the ratio (i.e., 23.6%, 38.2%, or 61.8%). Then, they have to subtract it from or add it to the high or low price, depending on the trend.
This has been a guide to What is Fibonacci Retracement and its Meaning. Here we discuss how to calculate Fibonacci retracement level and its uses. You may also have a look at the following articles to learn more –