One of the most popular tools used by traders for identifying potential reversal levels is called as Fibonacci Retracements. This popular technical analysis concept is helpful for determining the resistance and support level of any stock. This can then be used for entering new trades, exiting trades as well as setting the stop loss levels of trades.
Based on Fibonacci Sequence
Fibonacci Retracements are based on Fibonacci sequence. Fibonacci sequence is basically an infinite series of numbers which are formed by adding the preceding two numbers. It was identified in the thirteenth century by Italian mathematician Leonardo Pisano Bogollo.
The Fibonacci sequence of numbers is 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. Interestingly, each number is approximately 1.618 times greater than the previous number. 1.618 is therefore referred to as the Golden Ratio, Golden Mean, or Phi.
The Main Fibonacci Ratios
The key Fibonacci ratios used in the Fibonacci Retracement concepts are 23.6%, 38.2%, 50%, 61.8%, and 100%. These ratios usually act as a support or resistance level. In addition to the above-listed ratios, 50% as well as 78.6% retracement levels are also for identifying support or resistance.
- The ratio 23.6% is formed by dividing a number by another number that is three places to its right in the Fibonacci sequence. (eg: 13/55).
- The ratio 38.2% is formed by dividing a number by another number that is two places to its right in the Fibonacci sequence. (eg: 13/34).
- The ratio 61.8% is formed by dividing a number by the next number to its right in the Fibonacci sequence. (eg: 13/21). This is also called as the golden ratio or golden mean.
Steps to Create Fibonacci Retracement
First, the major peak and the trough of a stock is identified in the chart. Then the vertical distance between the two is divided into the key Fibonacci ratios. Then horizontal lines are drawn from those key Fibonacci ratios. These form the important support and resistance levels.
Whenever the price of a security or stock retraces to the level of any of the above ratios, the previously existing trend is usually likely to continue.
The figure below shows how a stock takes support at its key Fibonacci retracement levels before continuing its upmove. The support taken by the stock is marked on the chart.
Fibonacci Retracement And Trading
Traders make use of Fibonacci retracement levels when choosing their trades.
- If the stock is in an uptrend, traders enter long positions whenever the stock reaches its key Fibonacci Levels.
- If the stock is in a downtrend, traders enter short positions whenever the stock reaches its key Fibonacci Levels.
Traders also use Fibonacci retracement in conjunction with others like MACD indicator and stochastic oscillator.
- During an uptrend, whenever the price retraces to key Fibonacci levels and a bullish MACD crossover happens, traders go long.
- During a downtrend, whenever the price retraces to key Fibonacci levels and a bearish MACD crossover happens, traders go short.
- During an uptrend, whenever the price retraces to key Fibonacci levels and Stochastics show oversold, traders go long.
- During a downtrend, whenever the price retraces to key Fibonacci levels and Stochastics show overbought, traders go short.