Fibonacci Retracement: What Use Is It in Trading?

Fibonacci ratios are numbers that frequently come up in trading. But beyond that, they are very old numbers that date back to the years of the Renaissance. Originally, they were components of a fascinating mathematical progression, in which all numbers, if divided in the right way, are related to one another.

It gave birth to several repetitive percentages, including 23.6%, 38.2%, and 61.8%. These mysterious ratios also happen in nature, where one part of a flower can be exactly 23.6% the size of the other. Besides that, you can find these in the most unexpected places: space, anatomy, and, well, trading.

Fibonacci Retracement is an investing instrument, in which these numbers find their primary use.

fibonacci retracement

What Are Fibonacci Ratios?

In the 13th century, a great mathematician in Italy named Leonardo Fibonacci uncovered that if you start with 0 and 1, add them together, write the resulting number to the right and proceed to do it forever, you’ll have a mathematical progression with the most peculiar ratios.

Take any number and divide it by the one on its immediate right and you’ll receive 0.618 (or 61.8% of it). Do it with the second number to the right and you’ll get 0.382 (or 38.2%). You guessed it, the 23.6% is next. What’s more, if you divide one by the other, you’ll get the third.

These progressively smaller percentages imposed one over the other create a ‘Golden Ratio’. You must’ve seen it – it’s a spiral with the ever-reducing sections. They don’t just reduce haphazardly, but via the proportions we just described.

So, what does it have to do with trading? These numbers – 0.618, 0.382 & 0.236 – find use is some indicators, but chiefly in a method called Fibonacci Retracement.

Fibonacci Levels Explained

If you take any 2 points on the graph (the usual choice for many traders are highs and lows of some prices they care about), the distance between them could be charted with several horizontal lines. 

These lines (or levels) lie exactly on the Fibonacci numbers. Here are detailed instructions on how it works (don’t worry, the Retracement comes into play soon enough, just focus on this one for now):

  1. Pick a high point and assume it’s a 0
  2. Pick a low point and assume it’s a 1
  3. The Fibonacci Retracement Indicator will automatically draw the lines in several points between 0 and 1 – including 0.382, 0.5 and 0.618

The 0.5 would be right in the center, obviously. The other two would be close below and close above, at the same distance of 0.118. That’s why 0.5 is also often drawn as a Fibonacci Level, even though it’s absolutely not one of the ratios. 

These Levels will help you understand what the Fibonacci Retracement is. That, in turn, will likely be helpful to you during your trading sessions. So, what’s Retracement?

Fibonacci Retracement Explained

‘Retracement’ in this context is when an asset grows in the price for some distance, and the next day it bounces back down a portion of the way. For instance, if one day it grows to $1000, and the next day (regardless of what the opening price was) the actual price ended up at $618, then the Retracement is at 38.2%.

(It’s not always this way, but it’ll give you an idea of how these numbers work).

Now, if you were to put your two points on the two ends of the original candlestick (the one that grew in price) and apply a Fibonacci Retracement Indicator there, you would see several Levels. In this particular example, the lines would lay at $618, $500, and $328 – the Fibonacci Retracement Levels of this particular stretch of price.

In our example, the price stopped at one of these Levels, and that would be an ideal situation because this indicator shows where the Retracement will most likely stop. That’s the primary use of these numbers in trading.

How does it work?

The reason why the price can stop at the Fibonacci Retracement Levels is that they often coincide with the local support and resistance levels. Let’s pause and recall what they are:

  1. Support is a level at the bottom of the chart (or a part of the chart) where bearish trends usually slow down and often turn around.
  2. Resistance is the complete opposite. It’s a level at the top of the chart (or a part of the chart) where bullish trends usually slow down and can turn around. 

These levels exist because the market participants naturally have different agendas. Unless the market is united in supporting a bearish or a bullish trend, there are always people who will try and reverse the current price movement and eventually succeed. Once the trend is overturned, it starts gaining momentum simply by existing.

As to reasons why support and resistance levels hang out around the Fibonacci Levels, it’s hard to explain. However, since they often do, it would be foolish to lose such opportunities just because understanding this phenomenon is too difficult of a task. 

How Can It Be Applied?

It’s applicable to any two points, not just the highs and lows of a single price movement. You can apply it to the highest and lowest points of the last month. What it’ll bring you is a picture of support and resistance levels projected for a month-long trend. 

It’s perfectly possible because if you’d look at the chart of prices from 5 years ago and until the present, you’ll see that it’s one big trend (the price rose from nothing to its current position, making it a positive trend). In turn, this huge trend consists of numerous smaller trends.

Both the former and the latter have their own support and resistance levels where these respective trends may or may not reverse. It’s not a guarantee that it’ll reverse, as you’ll understand; otherwise, the chart would stay within a single strip of prices forever. That’s why you don’t want to use the Fibonacci Indicator alone.

So, let’s now see how to use Fibonacci Retracement in practice.

Using Fibonacci Retracement in Practice

Once you’ve placed the two points on any spots you wish, the indicator will show you the expected levels of resistance and support. Whenever the price is coming closer to these levels, you can expect it to turn back. It both applies to the bullish and bearish trends, depending on where the price comes from: below or above.

As mentioned, it’s not guaranteed that it’ll reverse from there. However, if it stopped at one of the Fibonacci Levels, the chances increase. They increase even more if you can see signs of a possible reversal: disproportionate supply/demand, long preceding growth/fall, evident reversal candlestick patterns or signs of reversal at these points prior on the chart.

If you look at all the evidence and decide that the trend is indeed going to reverse, a good call would be to open a suitable trading position. If the trend fell from above, then you can try a long trade. If it is knocked from below, you can try shorting the stock (if you’re confident in your abilities).

Summary

Fibonacci Retracement is not one of the most trustworthy indicators. It does need help from other indicators that also estimate reversal patterns. In conjunction with the other tools, the Fibonacci Indicator can be a fine addition. 

Despite being helpful in proving the already existing suspicions, it’s very popular among traders of all kinds. Naturally, the more seasoned investors won’t just take the advice Retracement gives them for granted. But it’s a good first lead that there may be a reversal very soon.

Yes, I want access to free training

Written by:

author

Carolyn Huntington is an economist, professional trader, and analyst. She made her first big deal in her student years with a profitable investment in Facebook stock. Now the total experience of her trade is 18 years. Over the years of trading, Carolyn has developed its own strategy that allows even those who have never traded on the stock exchange before to earn money. She also creates market forecasts and advises major shareholders, compiles investment portfolios, and teaches how to work with automated advisors.

telephone: 503-547-5192