What you are about to read here:
A lot of Forex traders use Fibonacci retracement ratios in their trading. On the page related to the Fibonacci theory of Learn Forex Trading, we explained this in general. So, if you are not familiar with it, we definitely recommend that you follow this article and the following articles about Fibonacci extension ratios and Fibonacci combinations with support and resistance.
Fibonacci is a very broad topic and many different studies with strange names have been done in this field, but we want to examine it from zero to one hundred. So let’s first introduce you to Mr. Leonardo himself in this article from TraderNova!
What are fibonacci retracement ratios?
Fibonacci retracement ratios, derived from the Fibonacci sequence, are horizontal lines that show where support and resistance, or in other words supply and demand, may occur in forex due to Forex news and other reasons.
Each level comes with a percentage. The percentage shows how much the price has retraced from a previous move. Fibonacci retracement ratios are 23.6%, 38.2%, 61.8% and 78.6%. While not officially a Fibonacci ratio, 50% is also used.
This tool is useful because it can be drawn between two important price points such as a ceiling and a price floor. Thhis retracement ratios indicator then creates a retracement between those two points.
Suppose the price of a share increases by $10 and then decreases by $2.36. In that case, it has retraced 23.6%, which is a Fibonacci number. Fibonacci numbers are found throughout nature. Therefore, many traders believe that these numbers are also relevant in the financial markets, as stated in Forex Factory as well.
Fibonacci retracement ratios are named after the Italian mathematician Leonardo Pisano Bigolo, better known as Leonardo Fibonacci. However, Fibonacci did not create the Fibonacci sequence. Instead, Fibonacci introduced these numbers to Western Europe after learning about them from Indian traders. Fibonacci retracement levels were formulated in ancient India between 450 and 200 BC.
Important points of Fibo-retracement
Fibonacci retracement ratios connect two points that the trader considers relevant, usually a high point and a low point.
The percentage levels provided are areas where price may stall or reverse.
The most common ratios include 23.6%, 38.2%, 50%, 61.8% and 78.6%.
These levels should not be relied upon exclusively, so it is dangerous to assume that price will reverse after reaching a certain Fibonacci level.
Fibonacci numbers and sequences were first used by Indian mathematicians centuries before Leonardo Fibonacci.
Fibonacci retracement ratio formula
Fibonacci retracement ratios do not have a formula like the ichimoku cloud. When these indicators are applied to the chart, the user selects two points. After selecting those two points, the lines are drawn as a percentage of that movement.
Suppose the price rises from $10 to $15 and these two price levels are the points used to draw the retracement Fibonacci. Then, the 23.6% level would be at $13.82 ($15 – ($5 × 0.236) = $13.82). The 50% level would be $12.50 ($15 – ($5 × 0.5) = $12.50.
Fibonacci retracement ratios can be used to enter trades, set stop-loss levels, or set price targets or take-profits. For example, a trader may see a stock going up. After an upward movement, it reaches the level of 61.8% again. Then, it starts to rise again.
Since the jump in the Fibonacci level occurs during an uptrend, the trader decides to buy. The trader may set a stop loss at the 61.8% level, as a drop below this level could indicate a failure of the bullish rally.
Retracement Ratios are also created in other ways in technical analysis. For example, they are common in Gartley patterns and Elliott wave theory. After a significant price move up or down, these forms of technical analysis show that reversals tend to occur near certain Fibonacci levels.
When other analysis tools are used alongside the Fibonacci retracement ratios, market trends are more accurately identified.
Retracement levels are fixed unlike moving averages. The fixed nature of price levels allows for quick and easy identification. This helps traders and investors react cautiously when price levels are tested. These levels are turning points where some form of price action, either a reversal or a breakout, is expected.
Fibonacci retracement vs. extension
While retracement fibonacci finds percentages for price retracements or corrections, Fibonacci retracements apply percentages to move in the direction of the trend. For example, a share goes from $5 to $10 and then back to $7.50. Moving from $10 to $7.50 is a correction.
If the price starts to rise again and reaches $16, this is a Fibonacci extension.
Limitations of using these ratios
While fibonacci retracement levels indicate where price may find support or resistance, there is no assurance that price will actually stop there. This is why other confirmation signals are often used, such as the price starting to bounce from the desired level.
Another argument against retracement levels is that there are so many of them that price is likely to reverse very often near one of them. The problem is that traders are trying to figure out which one will be most useful at any given time.
When it doesn’t work, it can always be argued that the trader should have followed another Fibonacci level instead.
Why are Fibonacci retracement ratios important?
In technical analysis, Fibonacci retracement levels indicate key areas where a stock may reverse or stop. Common ratios include 23.6%, 38.2%, and 50% among others.
Typically, these occur between a high point and a low point for a security, which is designed to predict the future direction of its price movement.
How to apply retracement ratios in a chart?
As one of the most common technical trading strategies, a trader can use retracement ratios to indicate where to enter a trade. For example, a trader notices that a stock is down 38.2% after a significant move.
As the stock starts to trend higher, they decide to enter the trade. Since the stock has reached a Fibonacci level, it is considered a good time to buy, and the trader speculates that the stock will then retrace or recover its recent losses.
Fibonacci retracement ratios is a useful tool that helps traders identify support and resistance levels. With the information gathered, traders can trade, identify stop-loss levels and set price targets.
Although retracement is useful, traders often use other indicators to more accurately assess trends and make better trading decisions.