Basics

All About Fibonacci Retracements

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Fibonacci retracements are not a purely stock market indicator, but it bases its theory on the fact that the market moves rhythmically and that the Fibonacci sequence is present in this rhythm. Fibonacci retracements are a graphical analysis tool that establishes support and resistance zones by dividing the height of a market move into levels derived from the Fibonacci ratios.

The most popular Fibonacci retracements are 61.8% and 38.2%. Note that 38.2% often rounds to 38% and 61.8 rounds to 62%. After a breakthrough, chart analysts apply Fibonacci ratios to define retracement levels and predict the magnitude of the correction. Fibonacci retracements are also applied after a dip to predict the length of a possible bounce.

These levels should not be used as input to our trading system, but should be combined with other indicators and price patterns to create an overall strategy.

Fibonacci sequence and ratios

With this article I do not intend to delve into the mathematical properties behind the Fibonacci sequence and its Golden ratio, but it is necessary to know some basic concepts that provide the necessary training to understand these popular numbers and for some … magical?

The introduction of the Fibonacci sequence in the West is credited with Leonardo Pisano Bogollo (1170-1250), an Italian mathematician from Pisa. Between these numbers there are a series of mathematical relationships that are repeated in nature, architecture, art and biology on countless occasions. All those living beings, plants, buildings, objects, etc., that keep these proportions are considered to meet the canons of universal beauty (human behavior is reflected in the market and gives a “natural” character to their movements). The sequence is as follows:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 ……

The sequence extends to infinity and contains many unique mathematical properties.

  • After 0 and 1, each number is the sum of the two previous numbers (1 +2 = 3; 2 +3 = 5; 5 +8 = 13; 8 +13 = 21; etc.).
  • A number divided by the number above approaches 1.618 (21/13 = 1.6153; 34/21 = 1.6190; 55/34 = 1.6176; 89/55 = 1.6181). The approximation gets closer to 1.6180 as the numbers increase.
  • A number divided by the later number approaches 0.6180 (13/21 = 0.6190; 21/34 = 0.6176; 34/55 = 0.6181; 55/89 = 0.6179; etc.). The approximation gets closer to 0.6180 as the numbers increase. This is the basis for the 61.8% retracement.
  • A number divided by the number two places later approaches 0.3820 (13/34 = 0.382; 21/55 = 0.3818; 34/89 = 0.3820; 55/144 = 0.3819; etc.). The approximation gets closer to 0.3820 as the numbers increase. This is the basis for the 38.2% retracement. Also note that 1 minus 0.618 = 0.382
  • A number divided by the number in three places later approaches 0.2360 (13/55 = 0.2363; 21/89 = 0.2359; 34/144 = 0.2361; 55/233 = 0.2361; etc.). The approximation is closer to 0.2360 as the numbers increase. This is the basis for the 23.6% retracement.

Between any number and the next there is always a correlation of 0.618. Between that number and the previous one, 1,618 also comes out. If we divide 1 by 0.618 it gives a result of 1.618. 1,618 is known as the golden number and is also called Phi. The inverse of 1.618 is 0.618.

After rising (A), the price retraces part of the movement (B) and then moves in the direction of the trend (C). A trader will study these pullbacks in order to initiate a long or short position.

How it forms

Fibonacci retracements are the most used tool of the group of analysis tools based on the Fibonacci sequence. To draw Fibonacci retracements we first identify the extreme points of a strong market movement and draw a vertical line whose height will be equal to the height between those two points. The vertical line will be divided by nine horizontal lines that cross the trend line at the Fibonacci levels: 0.0%, 23.6%, 38.2%, 50%, 61.8%, 100%, 161.8 %, 261.8% and 423.6%. After a significant rise or fall, prices often return to their previous levels thereby correcting a significant part (sometimes entirely) of their initial movement. During this move back, prices often find support or resistance at or near the levels of the Fibonacci lines.

In other words, take as the starting point the maximum of the oscillation if you are facing a downward movement and the minimum point if you are facing a bullish movement. The tricky thing is to take the maximum and minimum point properly. In this sense there will be differences between one trader and another. If you are looking at a graph, it seems obvious which is the minimum and the maximum, the problem is that each one looks at the graphs in a different way (different timeframes, different zooms, etc.).

Alert Zones

Fibonacci retracements are alert levels that traders and investors use to predict support and resistance levels in the market. The pullbacks are based on the previous move. The levels at which this retracement frequently ends or stops correspond to the horizontal lines of Fibonacci retracements. There are four common setbacks: 23.6%, 38.2%, 50%, and 61.8%.

The classical Fibonacci theory is that a 38.2% retracement within a trend is an abortive retracement and the overall trend holds. Also, a pullback to the 61.8% level signals the beginning of a new trend. Clearly, the 50% retracement is not based on a Fibonacci number. However, this number is derived from the Dow Theory’s claim that averages often traverse half of their previous move. The 50% level is probably the most common level and most trends tend to recede by 50% before continuing. Once the price starts to move back, you can draw the retracement levels on a price chart to detect signs of a change.

Based on depth, we consider a relatively shallow 23.6% retracement. These pullbacks would be appropriate for short pullbacks. Consider moderate setbacks in the 38.2% to 50% range. Although deeper, refer to the 61.8% retracement as the golden retracement. Shallow Fibonacci retracements do occur, but catching these requires closer vigilance.

Keep in mind that these retracement levels serve as alert zones for a possible entry into a trade. Traders at this point must use other aspects of technical analysis to identify or confirm if it is a valid entry. These can include candles, price patterns, oscillators, etc. Don’t buy automatically just because you are on a reverse level! Wait until you see a candle formation building up at the 38.2% level. If there are no signs of a pullback, then the price can move to the 50% zone. Check for a change. Plot these areas on a price chart and wait for an indication to open a long or short position.

Conclusions

The use of Fibonacci retracements to identify the end of a countertrend correction or bounce. Counter-trend corrections and rebounds often retrace some of the previous movement. While short reversals of 23.6% occur, 38.2-61.8% cover more possibilities (with 50% in the middle). This zone may seem large, but it is only a change alert zone. We need other technical signals to confirm an investment. If Fibonacci retracements are a useful tool, imagine yourself in combination with other technical analysis tools such as candles, stochastics, volume, or chart patterns. In fact, the more factors confirm it, the more robust the signal will be.

There is controversy over whether the financial markets really move according to these universal beauty canons. Maybe these levels began to function as support and resistance simply because many people believe that they work and buy when there is supposed to support and sell when supposed to resist.

Fibonacci retracements occur in a higher percentage than it would be logical to expect by pure chance. but they do not grant any advantage, since although the percentage of times they are fulfilled is greater than that which would occur by pure chance, it is not a percentage that is true. high enough. We must always keep in mind the main trend of the market, since it will allow us to draw Fibonacci retracements in the right direction, being able to catch better opportunities. As we already know, Fibonacci retracements only show us good levels where we expect to find support or resistance. As volatility increases, the greater the possibility that the market will ignore these support or resistance and therefore As we decrease the timeframe, the less effective Fibonacci retracements become.

The fact is that many investors use them to make their decisions, they go after them with partial knowledge, thus obtaining partial and/or negative results. Therefore it is good that we know them and know how to use them, but do not use them without using another tool to confirm it!

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