Fibonacci retracements are widely referred to as Fib retracement levels. Fibonacci retracement levels are horizontal lines that indicate the support and resistance in a trend. The support and resistance levels are based on Fibonacci numbers and each level indicates a percentage. The Fibonacci retracement levels are 23.6%, 38.2%, 61.8%, and 78.6% and show how much of a prior move the price has retraced.
Consider the support level as a floor that when the price passes above it or breaks it becomes the new resistance level. Likewise, consider the resistance level as the ceiling where the price is trying to breakthrough. When it does break through it becomes the new support level and vice versa.
Overall is used for technical analysis and can be used in any two significant price points/targets the trader chooses For example, assume a low price of $10 and a high point of $17. Placing the Fibonacci retracement between the two will create the levels for you.
Suppose the price of a stock was $10 and fell all the way to $3.82. In this case, the stock price has retraced 38.2% (3.82/10). In this example, the percentage happens to be a Fibonacci number. It is very common for Fibonacci numbers to be found and happen naturally therefore traders believe these numbers are relevant in the financial markets.
This technical analysis tool does not require any kind of formula. The trader chooses the two price points and places the indicator accordingly. The percentages of that movement are then drawn.
For instance, imagine a stock price rising from $5 to $15. These are the two prices you will use to place the retracements levels. The 23.6% level will be at $12.64 ($15 – ($10 * 0.236)).
They are from a string of numbers called the Fibonacci sequence. Leonardo Fibonacci introduced it in the 13th century. That sequence is a series of numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610… continuing to infinity. The sequence is formed based on mathematical calculations as follows: starting with the first two numbers of the sequence 0 and 1, each next number in the sequence is the sum of the previous two. Thus, the third number in the sequence is obtained, which is 1, and represents the sum of 0 and 1: 1 = 0 + 1. Then 2 = 1 + 1, then 3 = 1 + 2, 5 = 2 +3, 8 = 3 + 5, 13 = 5 + 8, 21 = 8 + 13, and so on.
If we divide some number from the sequence with the previous one, we get a ratio that is approximately 1.618. For example, 8/5 = 1.6, 21/13 = 1.6153, 34/21 = 1.6190, 55/34 = 1.6176, 89/55 = 1,6181… With increasing numbers in the series, the ratio tends to be 1,6180.
If, on the other hand, we divide a number from the sequence by the first next, the ratio will tend towards 0.618. For example, 13/21 = 0.6190, 21/34 = 0.6176, 34/55 = 0.6181, 55/89= 0.6179, etc. Of this number, 0.618 is one of the two most commonly used ratios, 61.8%.
It now follows how the 38.2% ratio came about. If we divide a number from the sequence by the number that is two places in front, we get 0.382. For example, 13/34 = 0.382, 21/55 = 0.318, 34/89 = 0.382, and so on. Notice that 1 – 0.382 = 0.618.
If we divide the number from the sequence by the number three places in front, we get 0.2360. Hence the ratio of 23.6%
The first number obtained in this way, 1.618, is the Golden Ratio that can be found everywhere in nature. Also, this number applies to architecture. That is why it is useful here as well because traders believe that this ratio is also relevant in the financial market. That is why this 0.618 retracement is also called Golden Retracement.
Along with that traders look at the 0.382 line as a common area for convergence, as the retracement will reach that point and stall on that line (see image below)
The traders also use a 50% ratio, although this is not officially the Fibonacci ratio. They consider this ratio as a midpoint of the price range. Yet, all these ratios should not be the only indicator. It can be dangerous if traders rely solely on these lines. It is not entirely sure that prices will reverse once when reaching these levels.
There are also Fibonacci ratios outside the given range, meaning outside 100%, and they are:
Fib retracement levels can be used for quite a few things. It can be used for identifying a stop-loss order, an entry price or to set price targets. For instance, when a trader sees a stock moving up and the price increases, it retraces to 61.8%. Once it moved up to this level it will move up again. Since the bounce occurred on an uptrend on the Fib retracement levels, the trader confirms a buy position. The trader might also decide to place a stop-loss order at 61.8%. If the price goes below the level it means that the rally failed.
Fib retracement levels occur in other technical analysis ways. For example, Elliot Wave Theory or Gartley patterns. Fib levels are static numbers that do not change, unlike moving average. The static numbers allow easy and fast identification. This helps traders to act as soon as the price target is reached whether it is a reversal or a breakout.
No matter how helpful the fib retracement levels can be they carry limitations. For example, identifying the support and resistance level can actually be successful but does not indicate if the price will stop there or continue in that direction. This is why other indicators are used along with it such as the price starting to bounce off the level.
Furthermore, another limitation is that due to the high amount of levels, it is very likely that the price will reverse near one of them often. The problem is that it is difficult for traders to understand which retracement level is a useful one at the given time. When it is not successful is usually due to this reason that means another level should be considered instead of the one used.