How to use the Fibonacci Retracement Tool

Majority of technical traders have used Fibonacci retracement at one point or another in their trading.

Majority of technical traders have used Fibonacci retracement at one point or another in their trading. This tool originated way back in the thirteenth century and was fronted by Leonardo Fibonacci, a popular mathematician back then.

He pointed a set of numbers and specific mathematical relationships in the form of ratios and series which were essential in technical analysis. Some of the numbers in this sequence are: 0,1,1,2,3,5,8,13,21,34,55,89,144…whereas the key ratios are 23.6%, 38.2%, 50%, 61.8% and 100%

Typically, for one to create a Fibonacci retracement, you start by identifying two extreme points on the stock chart. These two points should ideally be a significant peak and trough.

After identifying the two points, your next step is to divide the vertical distance using the Fibonacci ratios (aforementioned). After each level is marked on the vertical axis, the next step is drawing horizontal lines. These horizontal lines are used to point out any support and resistance levels.

The support levels are areas where the price has stopped going lower whereas the resistance levels are areas where the prices have stopped going higher.

 Fibonaci Retracement Image 1

The Fibonacci number Series

The sequence of numbers that are part of the Fibonacci number series could include: 0,1,1,2,3,5,8,13,21,34,55,89,144 and this could go up to infinity. When you closely look at this sequence, you would find out that each term is the sum of the initial two preceding terms.

A closer analysis reveals that there is a relationship with each term. Each term is greater than the preceding number by about 1.618 times. Thus, this is the underlying basis for the Fibonacci retracement ratios.

The Fibonacci Ratios

Having traced the roots of the Fibonacci ratios, let’s now consider the key ratios in an in-depth manner. The key ratios are 23.6%, 38.2%, 50%, 61.8% and 100%. Of these key ratios, 61.8% is considered as the golden ratio or in other places the golden mean. To find this ratio, you simply divide one term in the series by the term that follows it. An illustration: 55/89=0.6179, 0.6179*100=61.8%

To find the 38.2% ratio, you simply divide one term by the term that is located two places to the right.

To illustrate: 13/24=0.3824, 0.3824*100%=38.2%.

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To find the 23.6% ratio, you simply divide one term by the term that is located three places to the right.

To illustrate: 13/35=0.2363, 0.2363*100%=23.6%

These ratios are presumed to determine the reversal points of the price of assets in the stock market. Once the price of an asset has retraced to one of the ratios, it is likely it will continue in the direction of the previous trend it was having.

Fibonacci Retracement relevance to Traders

Traders out there that are carrying out technical analysis, can use the Fibonacci retracement to identify the points at which prices stop plummeting and the point at which prices stop rising. The horizontal lines indicate these points at the key levels (marked by the Fibonacci ratios) before the trend continues in its original direction.

These points are very useful for traders to make important decisions with regard to their investments. With the Fibonacci retracement tool, traders are able to know when to make a transaction in the market and also to prevent significant losses.

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Since the Fibonacci retracement price levels are static, one can analyze any upward or downward trend. One can be able to track the probable retracement of the initial move in the price of an asset.

Fibonacci Retracement Image 2

Typically in an upward trend, they can be reference points for any buying of stocks. In fact, most of the time they are the triggers of buying during an upward trend. Traders, in this case, employ the Fibonacci retracement to try and predict the extent to which it will pull back. On the other hand, during downward trends, they can be reference points for short selling and also an estimate of the bounce of the falling stocks.

The golden ratio 0.618 or 61.8% is often the point of no return so to speak. Any decision is affirmed at this point, be it short sellers and final buyers. It is where positions are changed in order to conform to the prevailing trend. The typical behavior of most traders is that they wait for about three candlestick closes above or below a certain Fibonacci retracement level so that they are resolute in supporting or resisting a certain stock before placing a trade.

Using the Fibonacci perspective, traders are able to see the larger picture with respect to uptrends and downtrends. Thus, with this kind of perspective, it is easier to see points at which they will make the most profit.

A point to note is that the Fibonacci level cannot be utilized on its own when performing a technical analysis. It is advisable to incorporate other technical indicators such as trend lines, momentum oscillators, moving averages, and candlestick patterns as well. Incorporating more indicators gives a more elaborate reverse signal.

While also utilizing this tool, watch out that you do not make the following common mistakes:

  • Mixing reference points. Reference points must always be consistent.
  • Ignoring long-term trends. This is a common rookie mistake, whereby traders focus on significant moves that are in the short term horizon at the expense of the long-term This is most commonly done when you watch a stock for a short period of say, two hours and you see downwards trends. While this might be the case for the two hours you have watched it, it might not be the case over a number of days say, seven days. The stock might actually be trending upward for a period of seven days however the downward trend you initially observed might have led you to a wrong and hasty conclusion.
  • As earlier mentioned, don’t solely rely on the Fibonacci retracement tool. Use it amongst other tools of analysis like stochastic oscillators. Stochastic oscillators verify the results you obtain firm a Fibonacci retracement, thus enabling you to settle on a potentially good trade.

In conclusion, the Fibonacci retracement tool is indeed a useful tool to estimate support and resistance points in trading. Use it wisely in conjunction with other forms of tools in technical analysis for better trading.