the introduction
There are a wide range of technical analysis tools and indicators that traders use to try to predict future price movements. These tools may include frameworks for complete market analysis, such as the Wyckoff Method, Elliott Wave Theory, and Dow Theory. These tools may also be indicators, such as moving averages, relative strength index (RSI), stochastic RSI, Bollinger bands, Ichimoku cloud range, parabolic stop and reversal indicator, or moving average convergence-divergence.
The Fibonacci Retracement Tool is a popular indicator used by thousands of traders in the stock markets, hard currencies, and digital currencies. What is amazing is that this indicator is based on the Fibonacci sequence discovered more than 700 years ago.
This article will explain the Fibonacci retracement tool and how to use it to identify important levels on a chart.
What is Fibonacci retracement?
Fibonacci retracement is a tool used by technical analysts and traders to attempt to anticipate important areas on a chart, using Fibonacci ratios as percentages. The Fibonacci retracement tool is derived from a number sequence identified by mathematician Leonardo Fibonacci in the 13th century, called the Fibonacci sequence. Certain mathematical relationships between the numbers in this sequence create ratios that can be represented by a graph. These ratios are:
%0
%23.6
%38.2
%61.8
%78.6
%100
While it is not technically a Fibonacci ratio, some traders consider the 50% level to have some significance because it represents the midpoint of the price range. Fibonacci ratios can also be used outside the range of 0-100%, such as 161.8%, 261.8%, or 423.6%.
We will discuss how traders can use these ratios, but the main point here is that the levels determined by the ratios can be linked to important levels in the market. When represented in a chart, Fibonacci levels can be used to identify important areas, such as support, resistance, retracement areas, entry points, exit targets, and stop-loss levels.
How to calculate Fibonacci retracement
Since these ratios are equal in each Fibonacci retracement tool, we do not have to perform manual calculations, but the way to obtain these ratios starts with Fibonacci numbers.
Let's make a sequence of numbers starting with zero and one, and add the sum of the previous two numbers to the current number. If we continue this indefinitely, we get a sequence of numbers known as the Fibonacci sequence.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987... and so on.
These numbers, of course, are not represented directly on the price chart. But the levels used in the Fibonacci retracement tool are all derived from these numbers in some way.
With the exception of a few numbers at the beginning of the sequence, if we divide one number by the next number, we will always get a ratio close to 0.618. For example, if we divide 21 by 34, we get 0.6176. If we divide one number by the number after the next, we get a ratio close to 0.382. For example, if we divide 21 by 55, we get 0.3818. All ratios (except 50%) in the Fibonacci retracement tool are based on calculations in this way.
Fibonacci sequence and the golden ratio
As mentioned, the Fibonacci sequence was developed by mathematician Leonardo Fibonacci in the 13th century. The golden ratio (0.618 or 1.618) is a mathematical ratio derived from these numbers. But why is this number important?
The golden ratio describes the dimensions of an amazingly long list of cosmic phenomena, and can be found everywhere in nature. Think of atoms, stars, galaxy formation, snails, and even honeybees – everything from the smallest to the largest scales can include examples of this ratio.
Moreover, this ratio has been used by artists, engineers, and designers for centuries to create shots and compositions that delight the viewer. From the pyramids to the Mona Lisa to the Twitter symbol, many famous works of art and designs use the golden ratio in one way or another. It is clear that this ratio may carry some importance in financial markets as well.
How to use Fibonacci retracement
Now that we know what the Fibonacci retracement tool is and how it works, we will look at its use in the financial markets.
Usually, the tool is drawn between two important price points, such as the highest and lowest price levels, and this range is then used as the basis for deeper analysis. The tool is usually used to plot levels within the range, but it may also provide information about important price levels outside the range.
This range is usually drawn according to the underlying trend. So, in the case of an uptrend, the lower level would be 1 (or 100%), while the upper level would be 0 (0%). By drawing Fibonacci retracement lines on an uptrend, traders can get an idea of potential support levels that could be tested if the market starts to bounce – hence the term retracement.
And vice versa, in the case of a downtrend, the lowest point will be 0 (0%), and the highest point will be 1 (100%). Note that the price is in a downtrend, so a bounce in this case indicates a price move from below (jump). In this context, the Fibonacci retracement tool can provide information about potential resistance levels if the market starts to rise.
Fibonacci levels and their significance for traders
Traders use Fibonacci ratios to choose entry zones, price targets, and potential stop-loss ranges, which can change significantly depending on an individual's setup, strategy, and trading style.
Some strategies involve profiting from the range between two specific Fibonacci levels. For example, assume an uptrend followed by a bounce. In this case, buying at the 38.2% retracement level and selling at the 23.6% level might be an interesting strategy. This of course depends heavily on the individual strategy and more technical factors.
Fibonacci levels are often combined with Elliott Wave theory to find the correlation between wave structures and potentially important areas. This strategy is powerful in predicting the extent of retracement in different waves within a given market structure.
As with other methods, the Fibonacci retracement tool is powerful when used with other indicators for technical analysis. There are signals for buying and selling that may not be sufficient alone, but they may be confirmed by looking at other indicators. So, if the price reaches a certain Fibonacci level, it may or may not rebound. It is necessary to manage risks carefully, taking the market environment and other factors into account.
Fibonacci extensions
As we mentioned, Fibonacci levels can be used to reevaluate retracement and jump areas (represented by the number 1 in the animation below). But in addition to that, the Fibonacci sequence can also be used to identify important levels outside the current range. These levels are called extension levels.
Fibonacci extension levels can be considered potential trading targets, and each trader may choose a different extension level as his target (or several targets). The first extension levels are 138.6%, 150%, and 161.8% - followed by 261.8% and 423.6%. Therefore, Fibonacci extension levels may indicate areas where the next price move may end.