What is a Fibonacci Retracement Level?
Does the name Fibonacci ring a bell? In 1202 Leonardo of Pisa, also known as Fibonacci, wrote the book Liber Abaci introducing a numerical sequence where each number is the sum of the two preceding ones. In other words, for those who still remember their school maths:
Fn = Fn-1 + Fn-2, n>1
The Fibonacci sequence is particularly interesting because, as n increases, the ratio of two consecutive numbers tends to the golden ratio (0.618). And the golden ratio is everywhere, from computer algorithms to galaxy formations to a pineapple’s fruit sprouts.
So, what do pineapples have to do with trading?
You may not be surprised to hear that technical analysts , who focus on charts rather than macroeconomics to predict future price movements, find Fibonacci and the golden ratio useful in identifying swing points where the price trend is about to reverse.
First, we need to explain where the percentages for this calculations come from. The ratio of two consecutive numbers in the Fibonacci sequence is 61.8%. If, however, you divide a number not with the one next to it but with its second to the right, you get 0.382 or 38.2%. If you divide it with its third to the right, you get 0.236 or 23.6%. And so on.
Now, this is how it works in trading: You start by identifying the highest point a price tends to reach, i.e. the resistance level, and you draw a horizontal line which is your 100%. Then you find the lowest price point, i.e. support level, and draw another horizontal line which is your 0%. You divide the space between these two by drawing horizontal lines at 23.6%, 38.2%, 61.8% and 78.6%. Most traders will throw an extra horizontal line in at 50%. These are the Fibonacci retracement levels and they are the levels where the price is most likely to stall or bounce.
In Lesson 16 , we explained that knowing when to enter and exit a trade is really important and you need to identify the swing points, where the price trend is about to change direction as this is when you need to make your move. Are Fibonacci levels accurate? Well, prices do tend to bounce at these levels but it’s not an exact science so you shouldn’t rely solely on them. Moreover, there are so many levels that, statistically, the price will bounce there or at some point nearby.
So, it’s good to know the theory and to apply it with caution but don’t over-depend on it.
Bitesize basics
- Fibonacci retracement levels are price points where we expect the trend to stall or reverse. These swing points are ideal for entering and exiting trades.
- They sit at specific internals between the low and high point of a trend, i.e. at 23.6%, 38.2%, 50%, 61.8% and 78.6%.
- You can use Fibonacci retracement levels as an indicator but don’t rely solely on them for trading decisions.
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