Fibonacci Retracements can help traders find significant price points and predict levels of support and resistance. It is based on the Fibonacci sequence of numbers, identified by Leonardo Fibonacci in the thirteenth century. The relationships between those numbers are shown as ratios, and those ratios are used to identify possible reversal levels.
The Fibonacci Sequence and Ratios
The Fibonacci sequence of numbers is calculated by adding the two previous numbers to get the next number in the sequence, beginning with 0 and 1 and extending infinitely. Each number is roughly 1.618 times greater than the preceding number, also identified as the “Golden Ratio.”
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 ...
The common ratios used for retracements are 23.6%, 38.2%, 50%, and 61.8%.
The 23.6% ratio is found by dividing a number in the sequence by the number that is three places higher.
The 38.2% ratio is found by dividing a number in the sequence by the number that is two places higher.
The 61.8% ratio is found by dividing a number in the sequence by the number that is the next highest in the series. This is also the inverse of the “Golden Ratio.”
The 50% ratio is not a key Fibonacci ratio, but is commonly included as an important retracement level.
Using Fibonacci Retracements
In a trending market, Fibonacci retracements can help traders determine how much a market might retrace before resuming its trend. A retracement is plotted by taking a high and low on a chart, and dividing the vertical distance by the Fibonacci ratios. These significant values, as determined by the ratios, then act as Fibonacci levels and represent areas of support and resistance.