A Fibonacci retracement is a ratio that can be used to determine potential reversal levels. Found in the Fibonacci Sequence, the most common retracements are 38.2% and 61.8%, usually rounded to 38% and 62%. Following an advance, Fibonacci ratios are applied in order to define the retracement levels and to forecast a pullback or a correction’s extent. It is also possible to apply Fibonacci Retracements following a decline in order to forecast a counter trend bounce’s length. Traders can combine Fibonacci Retracements with other price patterns and indicators to define an overall trading strategy.
What is the Fibonacci Sequence and the Golden Ratio?
Although the Finbonacci Sequence and Golden Ratio are quite a complex mathematical concepts, there is only the need for a trader to understand the necessary basics in order to grasp the ideas behind the theory.
The sequence was introduced to the west by Leonardo Pisano Bogollo, who was an Italian mathematician in the late 12th and early 13th centuries.
The sequence works as follows:
- 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 and so on to infinity.
- Following 0 and 1, every number is found by adding the two previous numbers. For example 1+1=2, 2+1=3, 3+2=5 etc.
- Any number approximates 1.618 when divided by its prior number. E.g. 89/55=1.618, 55/34=1.6176 etc.
- When any number is divided by the next number, it will approximate .6180 e.g. 55/89=0.6179, 34/55=0.6181 etc. This forms the basis for 61.8% retracement.
- If a number is divided by a number that is found two places higher, it will approximaste .3820 e.g. 34/89=0.3820. This principle forms the basis for 38.2% retracement.
- When a number is divided by a number that is three places higher than itself, it will approximate .2360 e.g. 13/55=0.2363. This forms the basis for 23.6% retracement.
The Golden Ratio is a reference to 1.618, with the inverse of 1.618 being .618. In nature, biology, art and architecture these ratios can often be found. For example, the Golden Ratio is used to create the shape of playing cards, is found in snail shells and sunflowers and even the spiralling galaxies in space.
What do Fibonacci Retracement Levels Demonstrate?
A Fibonacci Retracement level alerts traders about a potential reversal in trends, support area or resistance area and are based on a prior move. Bounces are expected to retrace part of a prior decline while corrections are expected to retrace part of a prior advance. If a pullback begins, traders are able to identify a specific Fibonacci retracement level for monitoring. When a correction approaches this retracement traders become more alert and look for a potential bullish reversal. On the other hand, the inverse will apply to a corrective advance or bounce following a decline. After a bounce begins, it is possible to identify a specific Fibonacci retracement level for monitoring and as a correction approaches this retracement, traders start to look for a potential bearish reversal. Of course these retracement levels should not be considered to be hard reversal points but should serve as an alert zone instead. When this occurs, traders should use a different type of technical analysis to confirm and identify a potential reversal such as candlesticks, moving averages, momentum oscillators or price patterns.
Using Fibonacci Retracements to Identify Potential Reversal Levels
Advanced traders are able to use Fibonacci Retracelements to identify potential reversal levels and so to take advantage of this knowledge to make a profit on the markets. They can do this by drawing up a chart and then plotting five horizontal lines that relate to the five potential areas in which prices may retrace. When they are used with pricing movement, the ratios will stay true across any time frame which provides strong indicators as to where future levels of resistance and support may take place. When the asset prices begin to settle, these can be viewed as the levels that will indicate that prices are showing signs of stabilising. Fibonacci Retracements are best used over an elongated period of time, when market trends have been observed for an extended period. These ratios are useful in assessing binary options barrier points, however of course they are not foolproof and should never be taken as a sure thing. Although they can be seen as an indicator to potentially act, traders should always check using other verification tools and indicators to make a more informed interpretation of price again and to improve their chances of correctly forecasting price directions.
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- Fibonacci retracement (Wikipedia)
- How to use Fibonacci retracement to predict the market (www.scientificpapers.org)