There’s a wide range of technical analysis (TA) tools and indicators that traders may use to try and predict future price action. These may include complete market analysis frameworks, such as the Wyckoff Method, Elliott Wave Theory, or the Dow Theory. They can also be indicators, such as Moving Averages, the Relative Strength Index (RSI), Stochastic RSI, Bollinger Bands, Ichimoku Clouds, Parabolic SAR, or the MACD.
The Fibonacci retracement tool is a popular indicator used by thousands of traders in the stock markets, forex, and cryptocurrency markets. Fascinatingly, it’s based on the Fibonacci sequence discovered more than 700 years ago.
This article will go through what the Fibonacci retracement tool is and how you can use it to find important levels on a chart.
What is Fibonacci retracement?
Fibonacci retracement (or Fib retracement) is a tool used by technical analysts and traders in an attempt to predict areas of interest on a chart. They do so by using Fibonacci ratios as percentages. The Fib retracement tool is derived from a string of numbers identified by mathematician Leonardo Fibonacci in the 13th century. This string is called the Fibonacci sequence. Certain mathematical relationships between numbers in this sequence create ratios that are then plotted to a chart. These ratios are:
While technically not a Fibonacci ratio, some traders also consider the 50% level to have some significance, as it represents the midpoint of the price range. Fibonacci ratios outside of the 0-100% range may also be used, such as 161.8%, 261.8% or 423.6%.
We’ll discuss how traders can use these percentages, but the main point is that the levels outlined by them may correlate with significant levels in the market. When plotted to a price chart, the Fibonacci levels may be used to identify areas of interest, such as support, resistance, retracement areas, entry points, exit targets, and stop-loss levels.
How to calculate Fibonacci retracement
As these percentages are the same in every Fibonacci retracement tool, you don’t need to manually calculate anything. However, the way to get them is to start with the Fibonacci numbers.
Let’s create a sequence of numbers that starts with zero and one, and keep adding the sum of the two preceding numbers to the current one. If we continue this indefinitely, we get a number string that’s called the Fibonacci sequence.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987... and so on.
These numbers, of course, aren’t directly plotted to a price chart. But the levels used in the Fibonacci retracement tool are all derived from these numbers in some way.
Excluding the first few numbers, if you divide a number by the number that follows it, you’ll always get a ratio close to 0.618. For example, if you divide 21 by 34, you’ll get 0.6176. And if you divide a number by the number found two places to the right, you’ll get a ratio close to 0.382. For instance, if you divide 21 by 55, you’ll get 0.3818. All the ratios (except 50%) in the Fibonacci retracement tool are based on some calculations involving this method.
The Fibonacci sequence and the Golden Ratio
As mentioned, the Fibonacci sequence was identified by mathematician Leonardo Fibonacci in the 13th century. The Golden Ratio (0.618% or 1.618%) is a mathematical ratio that is derived from these numbers. But why is it such an important number?
The Golden Ratio describes the proportions of an astoundingly long list of phenomena in the universe and can be found everywhere in nature. Think of atoms, stars, galaxy formations, shells, even honeybees – everything from the smallest to largest scale may have examples of this proportion.
What’s more, it’s been used by artists, engineers, and designers for centuries to create aesthetically pleasing compositions. From the pyramids to the Mona Lisa and the Twitter logo, many famous works of art and design use the Golden Ratio in some way. As it turns out, this ratio might also have significance in the financial markets as well.
How to use Fibonacci retracement
Now that we know what the Fibonacci retracement tool is and how it works, let’s consider its use as a tool in the financial markets.
Typically, the tool is drawn between two significant price points, such as a high and a low. This range is then used as a basis for further analysis. Usually, the tool is used for mapping out levels inside of the range, but it may also provide insights into important price levels outside of the range.
Typically, this range is drawn according to the underlying trend. So, in an uptrend, the low point would be the 1 (or 100%), while the high point would be 0 (0%). By drawing Fib retracement lines over an uptrend, traders can get an idea of potential support levels that may be tested in case the market starts to retrace – hence the term retracement.