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Last Updated : Jun 29, 2019 09:33 AM IST | Source: Moneycontrol.com

Technical Classroom: How to use Fibonacci Retracement Levels in stock trading

Fibonacci retracement is a method of technical analysis for determining support and resistance levels

Moneycontrol Contributor @moneycontrolcom

Shabbir Kayyumi

A Fibonacci retracement is a popular tool among technical traders and is based on some key numbers. The origins of the Fibonacci series can be traced back to the ancient Indian mathematic scripts, with some claims dating back to 200 BC. However – in the 12th century - Leonardo Pisano Bigollo, an Italian mathematician who was known to his friends as Fibonacci, discovered Fibonacci numbers.

It is a popular tool that technical traders use to help identify price levels for transactions, stop losses or target prices. These retracement levels also provide support and resistance levels for a stock. However, it really becomes most effective when confirming signals or conditions identified by additional technical analysis tools.

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What is a Fibonacci Retracement?

Fibonacci Retracement is a method of technical analysis for determining support and resistance levels. It is named after the use of the Fibonacci sequence series. It is also based on the idea that markets will retrace a predictable portion of a move, after which they will continue to move in the original direction.

Fibonacci Retracements are ratios used to identify potential reversal levels, and the most popular Fibonacci Retracements are 61.8 percent and 38.2 percent.

Construction of Fibonacci Retracement

Fibonacci Series

Understanding underlying formula used for construction of Fibonacci Retracement levels helps traders to take prudent decision, while trading complex scenarios. Fibonacci numbers are a sequence of numbers in which each successive number is the sum of the two previous numbers. The Italian mathematician described a very important correlation between numbers and nature. He introduced this number sequence starting with only two numbers 0 and 1.

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, and so on.

The Fibonacci sequence starts from 0 1 and every number thereafter is built by the sum of the previous two.

Every number in the Fibonacci sequence is 61.8 percent of the next number.

Numbers in the Fibonacci sequence are 38.2 percent of the number after the next in the sequence.

Every number in the Fibonacci sequence is 23.6 percent of the number after the next two numbers in the sequence.

Fibonacci Ratios

1

The volume of each part of the Sea Shell matches exactly the Fibonacci numbers sequence. Thus, each part of this shell is 61.8 percent of the next. It works the same way with this aloe flower. If we separate the aloe flower into even particles, following the natural curve of the flower, we will get the same 61.8 percent result. This ratio is not only found in animals and flowers. This ratio is literally everywhere around us. It is in the whirlpool in the sink, in the tornados when looked at through satellite in space or in a water spiral.

The Fibonacci ratio is constantly right in front of us, and we are subliminally used to it. Thus, the human eye considers objects based on the Fibonacci ratio as beautiful and attractive. Also, big corporations like Apple and Toyota have built their logos based on the Fibonacci ratio.

Strong Uptrend

Defining the primary trend with Fibonacci requires one to measure each pullback of the security. If one sees a series of new highs with retracements of 50 percent or less, the stock is in a strong uptrend.

Sideways Market

If one sees retracements of 61.8 percent, 78.6 percent or 100 percent, the stock is likely in a basing phase before the next move.

The Fibonacci Retracement is available on most trading platforms, such as Tradingview and MetaTrader. The Fibonacci Retracement Candlesticks are also available on many free online charting sites, such as Investing.com, StockCharts.com and Yahoo! Finance.

Working of Fibonacci Retracement levels

- Countertrend moves tend to fall into certain parameters, which are often the Fibonacci Retracement levels.

- Fibonacci retracement levels are most frequently used to provide potential areas of interest. If a trader wants to buy, they watch for the price to stall at a Fibonacci level and then bounce off that level before buying.

- At the end of the day, Fibonacci is nothing more than simple retracement levels. These levels are the only representative of where a security could have a price reaction, but nothing is etched in stone.

- Fibonacci Retracements are displayed by first drawing a trend line between two extreme points. A series of six horizontal lines are drawn intersecting the trend line at the Fibonacci levels of 0.0 percent, 23.6 percent, 38.2 percent, 50 percent, 61.8 percent, and 100 percent.

- Unlike moving averages, Fibonacci retracement levels are static prices. They do not change. This allows quick and simple identification and allows traders and investors to react when price levels are tested. Because these levels are inflection points, traders expect some type of price action, either a break or a rejection.

- The retracement concept is used in many indicators such as Tirone levels, Gartley patterns, Elliot Wave theory and more.

2

- The percentage retracements identify possible support or resistance areas, 23.6 percent, 38.2 percent, 50 percent, 61.8 percent and 100 percent. Applying these percentages to the difference between the high and low price for the period selected creates a set of price objectives.

- Depending on the direction of the market, up or down, prices will often retrace a significant portion of the previous trend before resuming the move in the original direction.

- The idea is to go long (or buy) on a retracement at a Fibonacci support level when the market is trending up, and to go short (or sell) on a retracement at a Fibonacci resistance level when the market is trending down.

- For downtrends, click on the Swing High and drag the cursor to the most recent Swing Low.

- For up trends, do the opposite. Click on the Swing Low and drag the cursor to the most recent Swing High.

- Even though deeper, the 61.8 percent retracement can be referred to as the golden retracement. It is, after all, based on the Golden Ratio.

- The most commonly used ratios include 23.6 percent, 38.2 percent, 50 percent, 61.8 percent and 78.6 percent. These represent how much of a prior move the price has corrected or retraced.

- The 50 percent retracement is not based on a Fibonacci number. Instead, this number stems from Dow Theory's assertion that the Averages often retrace half their prior move.

- Fibonacci retracement levels are used by many retail and floor traders, therefore whether one trade using them or not, one should at least be aware of their existence.

3

- Like all technical indicators, it is important to use the Fibonacci Retracement in conjunction with other technical analysis tools.

Trading Technique:

The Fibonacci retracement tool plots percentage retracement lines based upon the mathematical relationship within the Fibonacci sequence series. These retracements can be combined with other indicators and price patterns to create an overall strategy. Key points about it are discussed below-

4

Buy Signal:-

Entry

- RSI (14): RSI should be below 50 marks.
- Fibonacci Retracement: Prices should be in between 50 percent – 61.8 percent fib retracement levels.
- SMA(14): candle close should be above 14 SMA.
- Trend: Uptrend (Higher high and Higher low)

Exit

- One can use multiple ways to book profit & exit, like RSI near 85 or prices below 14 DMA or 100 percent Fibonacci retracement.

Sell Signal:-

Entry

- RSI (14): RSI should be above 50 marks.
- Fibonacci Retracement: Prices should be in between 50 percent – 61.8 percent fib retracement levels.
- SMA(14): candle close should be below 14 SMA.

- Trend: Downtrend (Lower high and Lower low)

Exit

- One can use multiple ways to book profit & exit, like RSI near 15 or prices above 14 DMA or 100 percent Fibonacci retracement.

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First Published on Jun 29, 2019 09:33 am
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