Fibonacci Retracement

Fibonacci retracement uses number ratios to find price levels where markets may pause or reverse before continuing in the same direction, helping traders spot trends.
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Fibonacci Retracement
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3 mins read
21-November-2024

Most successful traders time the market to capitalise on favourable price movements. They can enter positions at opportune moments by identifying entry and exit points. Clear entry and exit strategies enhance risk management and contribute to overall trading discipline and consistency. 

Fibonacci Retracement levels are horizontal lines that indicate potential support and resistance levels. This technique is most effective in trending markets. It's considered a predictive technical indicator as it aims to forecast where the price might move in the future.

The theory suggests that after a price starts a new trend, it may retrace or partially revert to a previous price level before continuing its original trend direction.

What is Fibonacci retracement?

Fibonacci Retracement uses the mathematical relationship within the Fibonacci sequence to plot percentage retracement lines. These retracement levels identify potential support and resistance areas, helping traders set price targets.

Fibonacci Retracements are derived from specific Fibonacci Retracement numbers and the Golden Ratio. In mathematics, the Fibonacci sequence is a series of numbers where each number is the sum of the two preceding ones. The Fibonacci Retracement series is:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610.

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What Are Fibonacci Retracement Levels?

Fibonacci Retracement levels are a popular technical analysis tool used by traders to identify potential support and resistance levels in financial markets. These levels are derived from the Fibonacci sequence, a mathematical series where each number is the sum of the two preceding ones. Here are some important features if Fibonacci Retracement Levels-

  • Identifying potential reversals: Fibonacci Retracement levels can signal potential trend reversals, resistance, or support areas.
  • Percentage-based retracements: These levels are calculated as percentages of a previous price move.
  • Key levels: The most commonly used Fibonacci Retracement levels are 23.6%, 38.2%, 61.8%, and 78.6%.
  • Versatility: These levels can be applied to any significant price swing, such as a high to low or low to high.
  • Natural phenomenon: Fibonacci numbers are found in various natural patterns and have been used in mathematics for centuries.
  • Indian origin: While often associated with the West, Fibonacci numbers were first developed and used by Indian mathematicians like Acarya Virahanka as early as 200 BC.
  • Cautious use: While helpful, it's crucial not to rely solely on Fibonacci Retracements. Price action and other technical indicators should be considered for a comprehensive analysis.

How to use Fibonacci retracement?

The Fib retracement uses historical price movements and mathematical principles to help traders make informed decisions. Let us understand its practical application through simple steps:

Step I: Identify significant price movement

The process starts by identifying a recent significant price movement in the market. This movement could be a:

  • Swing high (the highest point reached before a decline) or
  • Swing low (the lowest point reached before a rise)

Once you have identified the significant price movement, you can use charting tools available in most trading platforms to draw “Fibonacci retracement lines”. These tools allow you to select:

  • The starting point (the swing high or swing low) and
  • The ending point of the price movement

After drawing the Fibonacci lines, the tool will automatically generate the Fib retracement levels based on the selected price movement. These levels include the key Fibonacci trading ratios, which are derived from the Fibonacci sequence. These ratios are:

  • 23.6%
  • 38.2%
  • 50%
  • 61.8%, and
  • 100%

Step II: Apply Fibonacci ratios

Once the significant price movement is identified, Fibonacci ratios are applied to that range. It must be noted that each of these ratios offers different interpretations and represents levels where the price of an asset might "retrace" or pull back before continuing its trend.

Step III: Interpret Fibonacci levels

For those who are unaware:

  • Each Fibonacci ratio corresponds to an expected level of retracement
  • The higher the Fibonacci level, the higher the chances of retracement

Let us understand how you can interpret the Fibonacci levels through the table below:

Fibonacci level

Interpretation

23.6% level
  • A shallow retracement
  • This level is often considered a:
    • Minor support or
    • Resistance level

38.2% level
  • A moderate retracement
  • This level is commonly watched for:
    • Potential entry points or
    • Support/resistance

50% level
  • It is not a Fibonacci number but is included as a common retracement level
  • This point indicates the halfway point of the retracement

61.8% level
  • A strong Fibonacci retracement level
  • Traders closely watch this level for expected market reversals

100% level
  • This level represents a complete retracement to the initial price movement
  • In other words, the price has returned to the exact level where the initial significant price movement began
  • For example,
    • Say the price initially moved from point A to point B
    • It reached point B representing the end of that movement
    • At 100% level, this price retraces to point A
    • Traders witness a complete reversal of the prior movement


Step IV: Predict price movements

Using these retracement levels, traders can anticipate:

  • Where can the price pause? or
  • When will the price move in reverse direction before continuing its trend?

Now, you can use Fibonacci retracement levels to make decisions on entry and exit points for trades. Also, you can manage risk by setting stop-loss orders.

Why do traders use Fibonacci retracements?

Traders use Fibonacci retracements to identify potential support and resistance levels during market pullbacks or retracements. These retracements are based on the mathematical principle of the golden ratio.

To calculate Fibonacci retracement levels, analysts draw six horizontal lines on a price chart:

  • 100%: The highest point of the price move.
  • 0%: The lowest point of the price move.
  • 50%: The midpoint between the high and low.
  • 61.8%: A significant Fibonacci level.
  • 38.2%: Another significant Fibonacci level.
  • 23.6%: A less significant Fibonacci level.

According to the golden ratio theory, these lines can indicate potential support and resistance areas where the price may pause or reverse its trend.

How to calculate Fibonacci Retracement Levels

Here is how you can calculate Fibonacci Retracement Levels-

  • Identify a price swing: Determine the highest high and lowest low of a recent price movement.
  • Calculate the price difference: Subtract the low price from the high price.
  • Multiply by Fibonacci Ratios: Multiply the price difference by the desired Fibonacci percentage (23.6%, 38.2%, 61.8%, or 78.6%).
  • Add or subtract:
    • Uptrend: Subtract the result from the high price to find the potential support level.
    • Downtrend: Add the result to the low price to find the potential resistance level.

Formula for Uptrend Retracement:

Uptrend Retracement = High Price - (Price Difference × Fibonacci Percentage)

Formula for Downtrend Retracement:

Downtrend Retracement = Low Price + (Price Difference × Fibonacci Percentage)

Using Fibonacci Retracement Levels in Trading

  • Identifying potential reversals: When the price reaches a Fibonacci level, it may reverse its trend.
  • Setting stop-loss and take-profit orders: Traders can use these levels to set their stop-loss and take-profit orders.
  • Timing entries and exits: Fibonacci levels can help traders identify potential entry and exit points.

How to time the market using Fibonacci retracement?

Let us study a hypothetical example and learn how you can identify the entry and exit points using Fib retracement levels.    

The scenario

  • Say you are looking at the stock of Company XYZ
  • You notice that Company XYZ's stock price has been trending upwards
  • It has reached a recent peak of Rs. 1500 per share
  • You decide to apply Fib retracement levels to the recent uptrend, from the swing low of Rs. 1000 to the swing high of Rs. 1500

The interpretation of Fibonacci levels

  • After applying Fibonacci ratios, you identify the following retracement levels:
    • 23.6% retracement level: Rs. 1359
    • 38.2% retracement level: Rs. 1293
    • 50% retracement level: Rs. 1250
    • 61.8% retracement level: Rs. 1207

Also read: Share market timing

The decision making

Entry point

Exit point
  • You observe that the price of Company XYZ's stock begins to pull back from its peak of Rs. 1500.
  • You wait for the price to reach a Fibonacci retracement level, such as the 50% retracement level at Rs. 1250
  • You believe this level could act as a strong support.
  • You decide to enter the market and buy the stock.
  • You observe that the stock price continues to rise after your entry.
  • It reaches a significant resistance level, such as the 38.2% retracement level at Rs. 1293.
  • You consider this as an exit point to:
    • Sell your shares and
    • Lock in profits
  • Alternatively, you can choose to set a trailing stop-loss order just below the 38.2% retracement level.
  • This kind of setting will protect your gains if the price reverses.


What is the difference between Fibonacci Retracements & Fibonacci Extensions

Fibonacci Retracements

Fibonacci Extensions

Indicates how deep a retracement should be

Indicates where the price will go following a retracement

Measures the pullback of a trend

Measures the trend impulse waves in the direction of the trend

Provides good entry orders and stop-loss levels in a trend trading strategy

Provides good reversal points in trend reversal strategies and good take-profit points.

Can be extensively used as a profitable strategy with other confluences

Can be used in taking profit strategies and may also show good trend reversal points

Fibonacci numbers are within the initial trend (38.2%, 61.8%, 50%, etc)

Fibonacci numbers are beyond the 100% Fibonacci level (1.618%, 2.618%, etc)


What is the benefits of Fibonacci retracement

Here are the benefits of Fibonacci retracement-

  • Pivot point determining accuracy. With the correct setting, they can quite accurately determine the moments of price reversals at early levels or confirm a change in the trend direction at later levels.
  • The tool can be used on assets of any markets and any timeframe. But there is a caveat: the higher the timeframe, the more accurate the signals. Although Fibonacci is a favorite tool of scalpers working on M1 and M5, the price noise causes errors.
  • Accurate display of market psychology. Most of the technical indicators are based on a formula that reflects the patterns of previous periods. Fibonacci levels are built on both a mathematical algorithm and the psychology of the majority – this can be taken into account when building a Fibonacci trading system.

What is the disadvantages of Fibonacci Retracement

Here are the Limitations of Fibonacci Retracement-

  • Subjectivity in identifying trend extremes: Determining the exact high and low points of a trend can be subjective, especially in sideways or choppy markets.
  • False signals: The tool can generate false signals, where the price may not reach or reverse at the predicted Fibonacci levels.
  • Incompatibility with automated trading: Fibonacci Retracement is a discretionary tool and cannot be directly implemented into automated trading systems or Expert Advisors.

Conclusion

Fibonacci retracement is a popular technical indicator that helps traders time the market by identifying key levels of support and resistance. It is based on historical price movements and mathematical principles from Leonardo Fibonacci in the 13th century. To begin using it, you will have to first identify significant price movements and then apply Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100%. Each ratio offers a distinct interpretation and can be used to predict price movements.

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Frequently asked questions

How does the Fibonacci retracement work?

Fibonacci retracement levels are prices, represented as horizontal lines on a chart, that suggest where support or resistance might emerge.
Each price level corresponds to a percentage value, indicating the extent of the retracement from a previous high point in the price movement.

How do you apply Fibonacci retracement?
Firstly, you will have to identify a significant price movement. Then, use any charting tool to draw Fibonacci lines. Lastly, interpret the retracement levels and anticipate market movements.
What is an example of Fibonacci retracement?

For example, the initial correction could be to the 23.6% Fibonacci level. If the correction continues, the next potential support levels are 38.2% and 61.8%.
As shown in the example below, the stock retraced to the 61.8% level (approximately 421.9) before resuming its upward trend.

Which timeframe is best for Fibonacci retracement?

Fibonacci Retracements are flexible technical analysis tools. Therefore, there is no single optimal timeframe for Fibonacci retracements, as it depends on the trader's strategy. Day traders favour shorter timeframes such as 15-minute or hourly charts, while swing traders and long-term investors often use daily or weekly charts to identify key support and resistance levels.

Where do you start the Fibonacci retracement?

The starting point for a Fibonacci retracement is determined by the recent price swing. You'll identify the swing high (the peak of the upward trend) and the swing low (the trough of the downward trend). The Fibonacci tool is then applied between these two points, with the swing high as the starting point (100%) and the swing low as the ending point (0%). This creates a range of retracement levels based on the Fibonacci sequence, which are often used to identify potential support and resistance areas.

How do you take profit with Fibonacci retracement?

Fibonacci retracements are used to identify potential support and resistance levels during a price correction. While they don't directly dictate profit-taking levels, they can help guide your decision-making. You could consider placing a take-profit order near the next significant Fibonacci level above your entry point. For example, if you bought at the 61.8% retracement level, you might set a take-profit order at the 78.6% or 100% level. However, it's important to combine Fibonacci retracements with other technical analysis tools and consider factors like market sentiment and overall trend direction to make informed decisions about profit-taking.

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