Fibonacci retracement is an important and interesting tool used by technical traders in stock markets around the world. It is a number theory-driven metric that can help traders analyse the buy and sell points of specific stocks. In the real world, the use of this tool is rather restricted, but there is ample scope for future technical trading.
This retracement derives its name from the Fibonacci sequence, which in turn was named after Leonardo Pisano Bogollo, known popularly as Fibonacci. Bogollo was a 12th century mathematician who lived in Pisa and whose work later gave birth to the Fibonacci numbers.
Fibonacci retracement levels can help determine a stock’s support and resistance levels. A stock’s ‘support’ level is when buyers are most likely to ‘enter’ or purchase that stock. A ‘resistance’ level indicates a stock’s maximum price point at which most sellers will be most likely to sell that crip.
In this article
What is Fibonacci Retracement?
Fibonacci retracements are based on the designated Fibonacci numbers and associated Golden Ratio.
In mathematics, Fibonacci numbers or a Fibonacci series is a sequence of numbers whose value is the sum of the preceding two numbers. The most commonly used example to highlight a Fibonacci series is the following:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610
There are two interesting aspects about this series of numbers –
1. You will notice that each number is the sum of its 2 immediate precedents. The sequence leads into infinity. Thus, we have:
89+144=233, and so on.
2. Note that when you divide any number with its preceding value, you will almost always get a ratio of 1.618. Thus,
And 233 divided by its preceding number 144 also yields the ratio of 1.618.
Fibonacci was the first man to notice this sequence and its curious coincidences. The ratio of 1.618 is known as the ‘Golden Ratio’. It is found everywhere in nature. From galaxy formations to the ideal proportions of a human face in art, to the construction of a DNA molecule, everything reflects this ratio.
In percentage measure, the ratio translates to 61.8%.
Fibonacci retracement levels are lines on a graph at which a stock’s potential buy and sell values, or resistance and support price levels, are drawn. In technical stock trading, these lines are set at 23.6%, 38.2% and 61.8%. It is worth noting that even these values form a Fibonacci sequence.
While it is not a Fibonacci number, 50% is also a part of Fibonacci retracement levels.
The retracement values can be drawn on a logarithmic chart with individual levels set at 23.6% to 50% and 61.8%. These are essential tools to a technical stockbroker who can identify the correct time to sell a certain stock.
Fibonacci in Stock Market
Although no sensible brokerage house relies solely on a Fibonacci retracement to identify a certain stock’s ‘call’ levels, it is a strong contributor. Both inter-day and intra-day trading of any stock can follow a noticeable Fibonacci sequence.
Whenever there is a strong upward or a negative/downward trend in a stock’s price, Fibonacci retracement levels are often noted. Also, any stock whose price is on a noticeable high run may retrace back once before moving again on the bourses.
For example, if a stock priced at Rs. 50 is currently moving up towards Rs. 100 or more, there is a high probability that it will first retrace to Rs. 70, thereby experiencing a negative curve, before reaching highs of Rs. 120 and above.
How Can Traders Use a Fibonacci Retracement Level?
Analytical traders can wait until a particular stock can correct itself and settle down to a stable sale price. Due to market volatility, it is essential that a trader takes the values of 23.6%, 38.2% and 61.8% into account before deciding to settle on a certain price to buy or acquire stocks.
There is no set formula to calculate Fibonacci retracement.
Instead, a trader simply chooses two points between the highs and lows of a stock’s price bands. Lines at percentages of Fibonacci retracement numbers are then plotted on the graph.
For instance, a trader can select a stock whose price has ranged between Rs. 100 and Rs. 150 on a trading day. The ‘retracement indicator’ can be calculated from these 2 price points. The 23.6% levels will be Rs. 138.2 or 150 (50 x 0.236). The next lines can be plotted likewise.
A trader who is using Elliot Wave Theory or Gartley Patterns in plotting the average rise and fall in stock prices can also use a Fibonacci retracement.
Limitations of Use in Real-World Situation
There are several limitations of Fibonacci retracement indicators in real-life stock exchange uses. The following are the most prominent ones
- It must be remembered that Fibonacci retracement indicates only static price levels. It is impossible to say for sure that a certain stock’s price will not exceed or stay below-predicted levels.
- Ultimately, many extraneous factors also determine the price of a stock. They have to be taken into account when determining their future.
- Since Fibonacci retracement levels are pretty close to each other, it is often tough for a master stockbroker to determine the accurate platform from which to predict a certain stock’s future.
Finally, since a stock’s S & R (Support and Resistance) values do not depend on the Fibonacci retracement values, they should never be the sole parameters taken into account by technical traders. At best, if the S & R values have a recognisable candlestick pattern, they can be taken as a determining value for a stock. The wise stockbroker and trader will take into account other, seemingly extraneous, factors too before making a move.