Fibonacci retracements are potential points of temporary reversal within two particular price levels on a chart. This indicator is so named because it functions based on using Fibonacci numbers as reversal points in a trend.
On market charts, the Fibonacci Retracement tool can be deployed to draw horizontal lines (0% and 100% Fibonacci ratios) at two different price areas on the chart. The areas are to the discretion of the trader and are very often areas where a price high and price low occurred on the chart. Once these lines are drawn, the Fibonacci percentages are then indicated between them with some more horizontal lines. The most popular Fibonacci Retracement ratios analysts use are 23.6%, 38.2%, 50%, 61.8%, and 78.6%.
It is noteworthy that although 50% is not a true Fibonacci value, it has been widely adopted in the markets. Furthermore, percentages outside the 0%-100% can also be used, but are not very common. Significant price actions are usually anticipated around Fibonacci Retracement levels. When a retracement occurs and it touches a Fibonacci percentage, it is usually expected to bounce back. For this to happen, it would mean the price of the asset retraced by that percentage. They should not be confused with Fibonacci Extensions, as they move in opposite directions. While Fibonacci Retracements deal with pullbacks moving against the trend, Fibonacci Extensions deal with movements along the trending direction.
When a Fibonacci Retracement occurs, it could help a trader in a variety of ways. As earlier stated, it is often used in determining levels of support and resistance. It could also help in the identification of potential entry points, exit points and stop-loss prices. For instance, a trader could use a Fibonacci percentage as an entry point if he notices a building bounce after a retracement to a Fibonacci percentage level. It could also be a potential stop loss level, as a breach below that percentage could also show a further nosedive in prices. Other technical analysis tools also employ Fibonacci retracements to predict reversals. Fibonacci Retracement values are constant, making it easier for traders to identify and use.
It is noteworthy that Fibonacci ratios are not accurate enough to be used in solitarily. They are, more often than not, used with other indicators to confirm values like support and resistance prices. Fibonacci ratios are many, making it a bit more strenuous to identify the right percentage in each instance.