What is Fibonacci Retracement in Technical Analysis? How to Use it in Stock Trading?
Technical traders often use the Fibonacci retracement, which is a tool based on some key numbers for analysing the stock market. In the 12th century, an Italian mathematician named Leonardo Pisano Bigollo, also known as Fibonacci, discovered the Fibonacci numbers.
Technical traders frequently deploy it as a technique to help them determine price levels for buy or sell orders, stop losses, or target prices. These retracement levels also serve as a stock’s level of support and resistance. However, it becomes most effective when combined with other technical analysis tools to draw conclusions.
Read on to learn more about Fibonacci retracement in the stock market in detail!
What is Fibonacci Retracement?
Fibonacci retracement is a technical analysis method that can be used to identify levels of support and resistance. Fibonacci retracement uses the Fibonacci sequence series and helps predict the notion that markets would retrace a predictable amount of a move before continuing to move in the original direction. It is a metric that is based on number theory and can be used by traders to analyse the buy and sell points of certain shares.
In other words, the support and resistance levels for a stock can be determined using Fibonacci retracement levels. When buyers are most likely to “enter” or buy a stock, that level is called “support.” A stock’s maximum price level at which most sellers are most likely to sell it is known as its “resistance” level.
How Does Fibonacci Retracement Work?
The Fibonacci numbers are: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.
This series has an infinite number of terms, each of which is simply the sum of the two numbers before it. The fact that each number in this series is around 1.618 times bigger than the one before it is one of its notable features.
The ratios that technical traders use to calculate retracement levels are built on this common relationship between each number in the series. Technical traders try to use these ratios to identify turning points where the price momentum of an asset is likely to change and make buy and sell decisions accordingly.
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What are Fibonacci Retracement Levels?
The important ratios, known as Fibonacci retracement levels, show where an asset’s price movement may slow down or stop. When the price of an asset makes a new high in an uptrend or a new low in a downtrend, traders employ the retracement levels. There may be a market correction or a trend reversal at those Fibonacci retracement levels, and the new high or new low is merely a momentary end to the trend.
For instance, if a stock price rises to Rs.10 and then falls to Rs.7.64, the stock is said to have retraced 76.4%, a Fibonacci number.
The following are the Fibonacci retracement levels:
0.236, 0.382, 0.500, 0.618, 0.764, 1.00, 1.382, 1.618
What are Fibonacci Extension Levels?
The important ratios that indicate where an asset’s price may move after a retracement or pullback are known as Fibonacci extension levels. Since many traders set their profit objectives at these levels, these are also potential areas where the price may change direction.
These levels are applied to an asset’s price in order to predict whether it will continue to trend upward or downward and reach new highs or lows. It is uncommon to draw extension levels using the first two fibonacci extension ratios, 0 and 0.382 (or 38.2%).
The following are the Fibonacci extension levels:
0, 0.382, 0.618, 1.000, 1.382, 1.618, 2.000, 2.618
How to use Fibonacci Retracement Levels?
When you anticipate a correction following a sudden upward or downward movement, you might use Fibonacci analysis in the stock market. It assists you in locating significant stops or probable levels of reversal following a loss or gain, as the case may be.
Any time the stock price makes a big move, either upward or downward, there is typically a good chance that it will draw back before continuing to move in the original direction. These Fibonacci retracement levels offer traders a good chance to open new trades in the trend’s direction.
The significant Fibonacci ratios are the retracements of 23.6%, 38.2%, 50%, and 61.8%. These ratios aid traders in determining the likely extent of the retracement and in choosing the appropriate trading position. While the 23.6% retracement is typically rather shallow and appropriate for flag breakouts or brief pullbacks, the 61.8% retracement is significantly deeper and is a crucial milestone because it is known as the golden ratio.
Additionally, retracements between 38.2% and 50% could be regarded as a moderate correction.
When the market is trending upward, traders go long (or buy) on a retracement at a Fibonacci support level. Additionally, when the market is trending downwards, traders go short (or sell) on a retracement at a Fibonacci resistance level.
How to Calculate Fibonacci Retracement Levels
While applying Fibonacci retracement to a stock price, you first start by picking two price points – a significant high and a significant low.
During a bullish market or when the market is trending upwards, the following formulas can be used:
Uptrend Retracement = High – ((High – Low) x Percentage)
Uptrend Extension = High + ((High – Low) x Percentage)
During a bearish market or when the market is trending downwards, the following formulas can be used:
Downtrend Retracement = Low + ((High – Low) x Percentage)
Downtrend Extension = Low – ((High – Low) x Percentage)
Using the high and low price points in the formulas above, one can calculate the Fibonacci levels.
Fibonacci Retracement Example
When a stock makes a sudden upward or downward movement, it typically tends to retrace before making the next move. For instance, if a stock has increased from Rs.500 to Rs.1000, it is likely to retrace its steps back to Rs.800 before increasing to Rs.1200. A trader can determine the potential size of the retracement by using the Fibonacci ratios, which are 61.8%, 38.2%, and 23.6%.
The stock starts its rally at Rs.380 and peaks at Rs.489. The move from Rs.380 to Rs.489 can be described as the Fibonacci upmove and after the upmove, one should expect a stock correction to last up to the Fibonacci ratios. For instance, 23.6% might be the first level up to which the stock can correct. The 38.2% and 61.8% levels should be checked if this stock continues to correct.
While software exists to calculate the retracement levels, they can also be calculated manually:
Upmove = Rs.109
61.8% of Fibonacci up move = 61.8% x 109 = Rs.67.36
Retracement @61.8% = Rs.489- Rs.67.36 = Rs.421.6
In the diagram, the stock had retraced up to 61.8%, which coincides with Rs.421.9, before it resumed the rally.
Similarly, values can be calculated for the other ratios as well. This can also be applied to downward trending stock prices.
How to Draw Fibonacci Retracement Levels
A technical analyst who is looking for potential support and resistance levels will choose two prominent points from the chart of a stock, typically the highest and lowest points over a specified duration, and divide the vertical distance by key Fibonacci ratios. After the levels are determined, horizontal lines are drawn to help market makers identify trading opportunities. There are Fibonacci retracement tools available as well that enable analysts to make trading decisions based on this method.
In an uptrend, one needs to attach the Fibonacci retracement tool on the bottom and drag it to the right, all the way to the top. 3 potential support levels, namely 0.236, 0.382 and 0.618 need to be monitored.
On the other hand, in the case of a downtrend, one must attach the Fibonacci retracement tool on the top and drag it to the right, all the way to the bottom and monitor the 3 potential resistance levels, which are 0.236, 0.382 and 0.618.
Strategies for Trading Fibonacci Retracement
Following are the various Fibonacci trading strategy that can be implemented:
1. When buying or selling an asset, use them to set stop losses.
2. The Fibonacci extension values will help you identify the areas to set price targets and take profit orders.
3. It is recommended to book profits before the prices calculated via the Fibonacci retracement tool since there is no guarantee a rally will always reach the price targets.
Limitations of Fibonacci Retracement and Extension Levels
1. Fibonacci retracement levels alone are not sufficient or foolproof indicators of price movement. They must be used alongside other indicators and extraneous factors.
2. Fibonacci retracement levels only indicate future static prices. It cannot be said with certainty that the stock price will not deviate from the predicted levels.
3. Fibonacci is a valuable tool for chart analysis; however, it only offers an approximate area of entry rather than a specific entry point.
Also Read: Investment Company: Types of Investment Companies and How to Choose One
Final Word
Trading individuals can use Fibonacci retracements to find levels of support and resistance. They can place orders, determine stop-loss levels, and set price targets using the information they have gathered. Many traders are successful in using Fibonacci ratios and retracements in order to place transactions within long-term price trends.
That said, it does suffer from its own set of limitations such as failing to offer a specific entry point (as it mostly indicates an approximate area of entry), or even to guarantee that the stock prices won’t deviate from the predicted levels.
Technical analysis is always effective when several tools are combined together in order to draw conclusions, and Fibonacci retracements shouldn’t be an exception. Combining it with other technical indicators would help reduce the scope of inaccuracies and, thus, enable the traders to make better trading decisions.
FAQs
Ans. The important ratios, known as Fibonacci retracement levels, show where an asset’s price movement may slow down or stop. When the price of an asset makes a new high in an uptrend or a new low in a downtrend, traders often employ the retracement levels. There may be a market correction or a trend reversal at those Fibonacci retracement levels, and the new high or new low is merely a momentary end to the trend.
Ans. The important ratios that indicate where an asset’s price may move after a retracement or pullback are known as Fibonacci extension levels. Since many traders set their profit objectives at these levels, these are also potential areas where the price may change direction.
Ans. The levels of the Fibonacci retracement are 23.6%, 38.2%, 61.8 %, and 78.6%. Additionally, traders use a retracement ratio of 50% which is the midpoint between 2 price positions.
Ans. As trading tools, Fibonacci retracements and extensions differ primarily in that extensions are frequently used to decide when to exit a trade. Retracements, however, are used to choose a favourable entry point and can also be used to formulate an exit plan.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
