What are Fibonacci Retracements ?
By Benny Yuen, CTO
Key Takeaways
Fibonacci retracements are a technical analysis tool used in trading to identify potential levels of support and resistance in an asset’s price movement.
Fibonacci retracements are based on the idea that prices will retrace a predictable portion of a move, after which they will continue to move in the original direction.
The Fibonacci retracement tool should be used in conjunction with other technical indicators such as moving averages or Bollinger bands, etc.
Understanding Fibonacci Retracements
Fibonacci retracements are a technical analysis tool that uses horizontal lines to indicate areas of support or resistance at the key Fibonacci levels before the price continues to move in the original direction.
As we know, the price of an asset does not simply move in one way. It always moves up and down repeatedly. And traders believe that stocks and indices tend to retrace their paths after making a large move in either direction. When forecasting retracement levels, technicians often refer to a series of magic numbers that may help make trading decisions. The Fibonacci sequence is one of them.
In the 1170s, a mathematical link between numbers was found by Leonardo Fibonacci. The Fibonacci sequence is a set of numbers, as in 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc., where each succeeding number equals the sum of the two preceding ones.
This led to the establishment of the important Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100%. (While not officially a Fibonacci ratio, 50% is also used.)
By dividing one number in the series by the one after it, the crucial Fibonacci ratio of 61.8% can be found. For instance, the ratio of 21 to 34 is 0.6176, and the ratio of 55 to 89 is approximately 0.61798.
By dividing a number in the series by the number of two spots to the right, the 38.2% ratio can be found. As an illustration, 55 divided by 144 results in a value of around 0.38194.
By dividing one number in the series by the number three places to the right, the 23.6% ratio may be calculated. For instance, 8 divided by 34 gives approximately 0.23529.
Fibonacci numbers are found throughout nature. Therefore, many traders believe that these numbers also have relevance in financial markets.
How to set up the Fibonacci retracement
In technical analysis, a Fibonacci retracement is created by taking two extreme points (usually a peak and a trough) on a stock chart and dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, and 61.8%.
Let’s take a look at the upward trend of the S&P from Jan 2020 to Jan 2023. Suppose we choose 2191.86 in March 2020 as the lowest point(0%) and 4818.62 in December 2021 as the highest(100%). The index rose during this period, which might be a part of the overall uptrend. According to the Fibonacci retracement formula, four horizontal lines are drawn, as shown in the chart below, which can help traders identify potential support levels for retracements, which are at 3815.2(61.8%), 3505.24(50%) or 3195.28(38.2%), etc.
Likewise, in a downward price trend, the key retracement levels calculated from the retracement ratios could serve as potential resistance. To draw the Fibonacci retracements levels on any charting platform, you can first find the drawing toolboxes: for TradingView, click on the Drawing icon that looks like a pen.
Then click from the toolbox and select the Fibonacci retracement tool.
Then you need to identify the most recent swing high and low on the chart and tap the two price points to plot the Fibonacci retracement tool.
However, a common problem with using this tool is identifying swing highs and swing lows. Different time frames paint a different picture, and people have different opinions about the highs and lows of the swings, making it difficult for the market to come to a consensus.
If the time ranges are different, you’ll see different charts, not to mention investors’ choice of swing highs and lows. No wonder investors can make different choices based on Fibonacci retracements. However, this is not a big deal, because opportunities and risks arise when perceptions differ.
But importantly, the Fibonacci retracement tool should be used in conjunction with other technical indicators such as moving averages or Bollinger bands, etc.
