What is Fibonacci Retracement?

Investors leverage numerous indicators during technical analysis. However, there is one method that was never made for the stock market and yet is used by investors to identify profitable stocks. The method called Fibonacci Retracement is one of the most interesting yet baffling techniques that seem to work effectively for investors without them knowing why.

Let’s take you back to the time when you used to study mathematics in school and had puzzle questions where you had to figure out the connection between previous number series to fill the blanks that followed.

2,4,16,256, ….., …… This is what Fibonacci Retracement is all about. In this blog, you will learn about a mathematical method called Fibonacci Retracement used by investors to do technical analysis and make informed investing decisions.

What is Technical Analysis?

Technical Analysis is the study ofchart patterns, graphs and diagrams on a screen. The idea is to understand price and volume trends and pick a specific stock. Technical analysis is based on the premise that historical price trends tend to repeat over time. In technical analysis, you sit with historical stock charts, look at price and volume data, and then plot various trends. Based on past wisdom to trade for the future. One of the most widely used ways to do technical analysis is to look at the past price patterns of the stock and compare them with the present price to understand the stock’s performance and potential.

What is Fibonacci Sequence and Fibonacci Retracement?

Fibonacci Retracement has become an integral part of technical analysis and is based on the principle of Fibonacci numbers. The Fibonacci series of numbers is a continuous sequence of numbers that starts from zero and moves ahead by adding the previous two numbers. For example, a Fibonacci series starting from zero would look like below:

0 , 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377

In the above sequence, you can see that the next number is the sum total of the previous two numbers:

5 = 2+3

21 = 8+13

89 = 34+55

377 = 144+233

The Fibonacci sequence can be extended to infinite numbers. However, it is not the numbers that are interesting but what they bring as a ratio. When you divide any number in the Fibonacci series by the previous number, the resulting ratio is always approximately 1.618. For example,

21/13 = 1.618

55/34 = 1.618

144/89 = 1.618

377/233 = 1.618

This ratio of 1.618 is called the Golden Ratio and is referred to as Phi. Investors use the Fibonacci numbers because of their consistency in the resulting ratios. For example, if you take a number in the Fibonacci series and divide it by the succeeding number, the ratio is always approximately 0.618. Here, you must know that these ratios are taken percentages, and the key ratios are 23.6%, 38.2%, 50%, 61.8%, and 100% that are a result of various dividing methods in the series.

In technical analysis, a Fibonacci Retracement is created by taking a peak and a trough (extreme points) on a stock chart. The vertical distance between these extreme points are calculated and then divided by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100%. Once the investors identify the levels using the Fibonacci Retracement, they draw horizontal lines on the stock chart to identify the support and resistance levels for the specific stock.

How do Fibonacci Ratios Work?

The Fibonacci ratios derive relationships in the human face, nature, galaxy formations etc. However, for unknown reasons, the Fibonacci Retracement, when applied to the stock market, seems to play an effective role to determine the critical support and resistance levels for a specific stock. The support level is the price around which, previously, a particular security/commodity finds incremental demand. Traders use this level to enter the stock. The resistance level is a price around which a stock finds incremental sellers. Traders use these levels to exit a long position or even short sell security.

Fibonacci Retracement can be applied to almost any trading instrument and is relatively simpler when compared to other technical indicators. This makes Fibonacci Retracement one of the most widely used indicators by investors to evaluate and analyse stocks. Investors apply the Fibonacci Retracement method when they witness a stock showcasing high volatility. With such volatility, it is always believed that the stock price will always retrace back before its next movement. For example, if a stock has reached Rs 500 from 250, it is likely to retrace back to Rs 350 before moving up to Rs 650.

The Fibonacci Retracement is used to identify the level at which the stock will retrace before moving in the opposite direction. These levels allow investors to identify resistance levels, draw support lines, put stop-loss orders and set a target price for the stock.

For a better understanding of Fibonacci Retracement meaning, consider the following example:

Suppose a stock started to rally from Rs 250 levels and peaked after it reached Rs 500. Here 250 and 500 are the extreme levels, and the Fibonacci move is Rs 250 (500-250).

Now, using the key Fibonacci ratios of 61.8, the move is defined as: 61.8% of 250 = 154.5

In this case, the Fibonacci Retracement at 61.8% will be = 345.5 (500-154.5).

This means that the price can fall to Rs 345.5 levels from Rs 500 before going up above the Rs 500 levels. This result helps investors find the ideal entry point as they can wait until the price falls to Rs 345.5 before entering the trade. Similar to using 61.8%, the Fibonacci Retracement levels can be found through ratios such as 23.6%, 38.2%, 50% and 100%.

Pros and Cons of Fibonacci Retracement

The Fibonacci Retracement proves to be an effective way for investors to draw the support lines and identify the resistance levels. As every stock is believed to retrace to the opposite level before it continues towards the trend, the Fibonacci Retracement proves useful for investors to identify the retracement levels and buy the stock where it retraces back. Furthermore, it is one of the easiest indicators to use. Every trading platform contains a tool that automatically calculates the Fibonacci Retracement levels and automatically draws the support lines.

However, the use of Fibonacci Retracement is subjective and has been known to make profits for some investors and losses for others. As there is no logical proof behind the effectiveness of the Fibonacci Retracement to evaluate stocks, there is no saying if it can work for a particular investment strategy. Furthermore, the Fibonacci Retracement can only signal towards a price correction, countertrend bounces and reversals without any strong or weak signals towards the price movements.

Final Words

The Fibonacci series was discovered in the 12th century by an Italian mathematician named Leonardo Pisano Bogollo, otherwise known to his friend as Fibonacci. Using the same series and its relationship with almost everything, the method of Fibonacci Retracement was created to find the support and resistance level. However, it is wise to use the Fibonacci Retracement in conjunction with other technical indicators.