Fibonacci Retracement

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on September 04, 2023

Are You Retirement Ready?

What Is Fibonacci Retracement?

Fibonacci retracement is a technical analysis tool used to identify potential levels of support and resistance in a market trend. It is based on the idea that markets will often retrace a predictable portion of a move, after which they will continue to move in the original direction.

The key levels used in Fibonacci retracement are 23.6%, 38.2%, 50%, 61.8%, and 100%. Traders use these levels to identify potential buying or selling opportunities when a market trend retraces to one of these levels.

Fibonacci retracement can be used in any market that exhibits trending behavior, including stocks, forex, and commodities.

Fibonacci Sequence and Ratios

The Fibonacci Sequence Explained

The Fibonacci sequence is a series of numbers in which each number is the sum of the two preceding ones, starting from 0 and 1. The sequence goes as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, and so on.

This sequence has unique properties, and the ratios between the numbers exhibit patterns that can be observed in various natural phenomena.

Key Fibonacci Ratios and Their Derivation

Fibonacci retracement is based on a set of key Fibonacci ratios, which are derived from the Fibonacci sequence. These ratios are:

  1. 23.6%: This ratio is derived by dividing a number in the sequence by the number two places to its right.

  2. 38.2%: Obtained by dividing a number in the sequence by the number one place to its right.

  3. 50%: Although not a Fibonacci ratio, this level is often included due to its significance in Dow Theory and as a midpoint.

  4. 61.8%: Derived by dividing a number in the sequence by the number one place to its left.

  5. 78.6%: This ratio is derived by dividing a number in the sequence by the number two places to its left.

Key Fibonacci Ratios and Their Derivation

The Golden Ratio and Its Significance in Fibonacci Retracement

The golden ratio, approximately 1.618, is a mathematical constant derived from the Fibonacci sequence. It is obtained by dividing a number in the sequence by the number immediately preceding it.

The golden ratio is considered significant in Fibonacci retracement as the inverse of this ratio (0.618 or 61.8%) is a crucial retracement level.

Applying Fibonacci Retracement to Trading

Identifying Trends

Fibonacci retracement can be applied to both uptrends and downtrends in financial markets. In an uptrend, traders use the tool to identify potential support levels, while in a downtrend, they use it to identify potential resistance levels.

Selecting the Appropriate Timeframe

The timeframe selection is crucial when applying Fibonacci retracement. Traders can use the tool on various timeframes, including intraday, daily, weekly, and monthly charts. However, it is essential to choose a timeframe that aligns with the trader's overall trading strategy and risk tolerance.

Drawing Fibonacci Retracement Levels

To draw Fibonacci retracement levels, traders plot the key Fibonacci ratios on a chart to create potential support and resistance zones. These zones, also known as confluence zones, are areas where multiple Fibonacci levels overlap, increasing their significance.

Applying Fibonacci Retracement to Trading

Fibonacci Retracement Strategies

Entry and Exit Points

Fibonacci retracement can help traders identify buying and selling signals in the market. When the price approaches a Fibonacci retracement level, traders may consider entering or exiting positions based on the anticipated reversal or continuation of the trend.

It is also essential to set appropriate stop-loss and take-profit levels to manage risk.

Combining Fibonacci Retracement With Other Technical Indicators

To enhance the effectiveness of Fibonacci retracement, traders often combine it with other technical indicators, such as:

  1. Moving Averages: These indicators help identify trends and potential reversal points in the market.

  2. Relative Strength Index (RSI): RSI is a momentum indicator that measures the speed and change of price movements, helping traders identify overbought or oversold conditions.

  3. Stochastic Oscillator: This momentum indicator compares a security's closing price to its price range over a specific period, assisting traders in identifying potential reversals.

  4. Candlestick Patterns: Traders use various candlestick patterns to identify potential entry and exit points, enhancing the effectiveness of Fibonacci retracement levels.

By combining Fibonacci retracement with these indicators, traders can develop more robust trading strategies that improve their chances of success.

Combining Fibonacci Retracement With Other Technical Indicators

Examples of Successful Fibonacci Retracement Trading Strategies

There are numerous trading strategies that incorporate Fibonacci retracement levels, including:

  1. Trend Continuation: Traders can use Fibonacci retracement levels to enter trades in the direction of the prevailing trend, targeting higher probability confluence zones.

  2. Trend Reversal: When combined with other technical indicators or chart patterns, traders can use Fibonacci retracement levels to identify potential trend reversals, entering trades when the market shows signs of changing direction.

  3. Breakout Trading: Traders can utilize Fibonacci retracement levels to identify potential breakout points in the market, entering trades when price action breaks through key support or resistance zones.

Limitations and Risks of Fibonacci Retracement

Subjectivity in Drawing Retracement Levels

One limitation of using Fibonacci retracement is the subjectivity involved in drawing retracement levels. Traders may interpret chart patterns differently, leading to inconsistencies in the placement of Fibonacci levels.

False Signals and Market Noise

Fibonacci retracement levels, like any other technical indicator, can produce false signals. The presence of market noise can sometimes lead traders to make incorrect decisions based on these levels.

Importance of Risk Management

As with any trading strategy, it is crucial to practice proper risk management when using Fibonacci retracement levels. Traders should set stop-loss orders and take-profit targets to protect themselves from adverse market movements.

Conclusion

Fibonacci retracement is a valuable tool in a trader's toolbox, offering insights into potential support and resistance levels in financial markets.

By combining Fibonacci retracement with other technical indicators and adhering to sound risk management practices, traders can develop robust trading strategies to increase their chances of success.

However, it is essential to remain aware of the limitations and risks associated with using Fibonacci retracement in trading.

Consult a financial advisor for further information on how Fibonacci retracement can help achieve goals and objectives in trading.

Fibonacci Retracement FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

Discover Wealth Management Solutions Near You

Find Advisor Near You