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Traders and technical analysts all over the world refer to Fibonacci retracements while placing their trades. A Fibonacci retracement is based on the Fibonacci series, a sequence where each number is the sum of its two preceding numbers.
The most commonly known sequence is 0, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233 and so on. If one pays close attention to the above sequence, one will see that:
8 = 3 + 5
21 = 13 + 8
89 = 55 + 34
144 = 89 + 55
Although the Fibonacci series usually starts with 0 and 1, any two numbers can be used to create a series. The series was named after its creator, a twelfth-century Italian mathematician called Leonardo Pisano Bogollo, known to his friends as Fibonacci. Continue reading the article to learn how the Fibonacci sequence is used by traders to trade in the stock market.
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Relevance to Stock Markets
The Fibonacci retracement helps identify support and resistance levels in a trend and predict its continuation. The Fibonacci retracement on a price chart plots horizontal levels or lines that function as support and resistance levels. Price pullbacks or price retracements generally tend to occur within the Fibonacci retracement levels. The Fibonacci retracement levels are plotted using the Fibonacci ratios of 61.8%, 38.2%, and 23.6%. In addition to these ratios, the 50% level is also generally used, although it is not a constituent of the Fibonacci series.
Thus, if the stock price was witnessing a major uptrend, the price may deviate from the original uptrend and take support near a Fibonacci level before it witnesses a reversal and resumes its uptrend; this essentially is a Fibonacci retracement.
The Formula for Fibonacci Retracement Levels
Let us go back to the Fibonacci sequence discussed in the first section: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987
The Fibonacci ratios of 61.8%, 38.2%, and 23.6% are derived from the Fibonacci sequence above. The Fibonacci sequence has multiple interesting properties:
- Baring the first three natural numbers, divide any of the numbers in the sequence by the preceding number, and one will get a ratio that is approximately 1.618. For example, divide 377 by 233 or 144 by 89, and one will see that the answer is 1.618. The ratio 1.618 is the Golden Ratio, which one may not know is visible in nature, architecture, music, art, etc.
- Likewise, if one divides a number in the sequence by its succeeding number, one will find out that the ratio obtained is always approximately 0.618. For example: 34/55 = 0.618 and 144/233 = 0.618.
- If one divides a Fibonacci number with a number two places higher up the sequence, it will be seen that the ratio obtained is always approximately 0.382. For example: 21/55 = 0.382 and 89/233 = 0.382.
- The trend continues, as a similar consistency is even visible when a Fibonacci number is divided by a number three places up the sequence; the ratio here is 0.236. For example: 13/55 = 0.236 and 55/233 = 0.236.
When these ratios are converted into percentages one gets:
0.618 = 61.8%
0.382 = 38.2%
0.236 = 23.6%
The above illustration is a depiction of how one obtains the Fibonacci ratios of 61.8%, 38.2%, and 23.6%.
Using Fibonacci Retracement Levels
Let’s explore how one can utilise Fibonacci retracement levels for trading. Assume one is a positional trader who missed a significant upward move in a stock. Instead of chasing the price, wait for a retracement, and use the Fibonacci retracement tool to identify potential levels at 61.8%, 38.2%, and 23.6%. Choose a suitable time frame, observe signs of the stock finding support at these Fibonacci levels, and then consider entering a buying position.
These Fibonacci levels can also act as resistance, so for short term trades, one may want to take profits near a Fibonacci resistance level. Combining the Fibonacci retracement strategy with a VWAP chart can enhance one’s understanding of price and volume dynamics, aiding in making well-informed trading decisions and identifying optimal entry or exit points based on market trends and potential reversals.
Limitations of Using Fibonacci Retracement Levels
As a trader or investor, one utilises Fibonacci levels to estimate the extent to which the price may retrace before continuing its original trend. However, it’s crucial to acknowledge that Fibonacci retracements, like other technical analysis tools, are not foolproof. The stock market’s unpredictability and the non-guarantee of future results based on past performance highlight the importance of using Fibonacci retracement levels as confirmation tools in conjunction with other indicators such as candlestick patterns, stop losses, and trading volumes.
A notable limitation of the Fibonacci retracement strategy is the multitude of levels where the price may reverse. Bouncing off one Fibonacci level acting as support does not ensure immunity from another reversal when approaching the next Fibonacci level serving as resistance. Therefore, it is essential to employ a comprehensive approach and consider various factors when incorporating Fibonacci retracement into the trading strategy.
Conclusion
Like all technical analysis tools, Fibonacci retracement levels aren’t foolproof for predicting market movements, but they can enhance the decision-making process. Use the Fibonacci retracement strategy alongside other tools to confirm trends and reversals. Strengthen one’s trade setup by aligning stop-loss levels with Fibonacci levels, increasing confidence in buying or selling decisions. In online share trading platforms like Share India, traders can integrate Fibonacci retracement levels into their strategies for more comprehensive trend analysis and increased confidence in their positions.