What is Fibonacci Retracement?
It is one of the widely used tools among traders. The Fibonacci retracement’s work is based on the important ratios which were identified by an Italian mathematician in the 13th century. It is useful in identifying strategic places for trades to be placed, target price, or stop loss. It can be plotted on the chart by taking two extreme values on a technical chart of an instrument and dividing the vertical area by the Fibonacci ratios. After this, horizontal lines are drawn to find possible price reversal points.
Why is Fibonacci analysis so popular in trading?
Fibonacci works on Golden Ratios, which are 61.8%, 38.2%, and 23.6%. We can find this ratio in real life, in fine art, and even in human faces. After many developments over the year, trades have successfully translated these ratios into an investment strategy.
The main aim of Fibonacci levels is that they act as reference points and help traders to clear out subjectivity, hence helping them in making an informed decision.
Fibonacci Levels in the Financial Markets
In trading Fibonacci retracements do not represent numbers in sequence, but it reveals the mathematical connection between numbers in it:
- The 61.8% level of Fibonacci also known as a golden ratio, is derived from dividing a number in the series by the number that follows it. For example, 89/144 = 0.6180.
- The 38.2% level is got by dividing a number in the Fibonacci series by the number two place to its right, for example, 89/377=0.2360.
- The 23.6% level is generated by dividing a number in the series by the number three places to the right. For example: 89/377 = 0.2360.
To use these Fibonacci retracement levels in trading, a trader should mark these levels between the high and low points on the chart. The Fibonacci extension can go beyond 100%, and a trader can use it to project target levels. The Fibonacci extension levels are 161.8%, 261.8% and 423.6%.
How to use Fibonacci in trading?
Before discussing the strategies for using Fibonacci retracement, I would like to make one thing clear just like any other technical indicator, Fibonacci is also not always reliable. But using Fibonacci in combination with other technical tools can help to clear out a lot of noses, and with experience, a trader can easily decide which signals to trade and which signals to leave.
Fibonacci levels work best when they converge with other support and resistance level, trend lines, or even with 50 and 200 days moving averages, hence providing a better signal for entry and exits.
Let us understand this with an example. Suppose a head and shoulder is forming. The right shoulder converges with the 61.8% or sometimes with 78.6% Fibonacci retirement level. Thus giving better signals to entry.