Introduction:

Fibonacci Retracement is a very fascinating indicator to look at. It is an overlay indicator which is used to find potential support and resistance levels. The indicator plots various horizontal lines that indicate possible S/R levels.

The indicator is calculated based on Fibonacci numbers. To understand the indicator and appreciate its origin, we will be covering all the topics right from what are Fibonacci numbers to how the indicator can be used to increase your odds while trading.

The Fibonacci sequence:

The first pieces of evidence of Fibonacci are found in Indian scripts dating as old as 200 BC. The sequence was introduced to the west through the book ‘Liber Abaci’ by Leonardo Bonacci, an Italian mathematician. He was also known as Fibonacci hence the sequence got its name.

The Fibonacci series is a number sequence beginning at zero and structured such that the value of any element of the series is the sum of the two numbers preceding it.

The Fibonacci sequence is :

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

In the above sequence, every number is a sum of 2 numbers preceding it. Eg. 34 = 21+13.

Fascinating properties of the Fibonacci sequence :

1] With the exception of the first few numbers, dividing any number by the previous number always yields a ratio of approximately 1.168

Examples: 233/144 = 1.168, 89/55 = 1.168

The ratio of 1.168 is also called the golden ratio. The golden ratio is a very interesting ratio that can be spotted in many naturally occurring things like flower petals, galaxies, trees, body parts, hurricanes, shells and numerous other things. It is such an interesting ratio that it deserves an article of its own.

2] With the exception of the first few numbers, dividing any number by the number succeeding it always yields a ratio of approximately 0.618

Examples: 144/233 = 0.618, 89/144 = 0.618. If we express 0.618 in percentages, it is 61.8%

3] With the exception of the first few numbers, dividing any number by the number two places higher than it always yields a ratio of approximately 0.382

Examples: 34/89 = 0.382, 55/144 = 0.382. Again, if we express 0.382 in percentages, it is 38.2%

4] With the exception of the first few numbers, dividing any number by the number three places higher than it always yields a ratio of approximately 0.236

Examples: 34/144 = 0.236, 55/233 = 0.236. If we express 0.236 in percentages, it is 23.6%

The Fibonacci Retracement Indicator :

Image 1: Fibonacci Retracement Indicator

The above image shows the Fibonacci indicator. The price retraced to 0.382 or 38.2% of the preceding up move i.e 5855.22 level, bounced back and resumed the up move. Fibonacci levels of 0.236, 0.282, 0.5, 0.618, 0.786 are marked. We saw the origin of other numbers earlier except 0.5 and 0.786. 0.5 is not derived from the Fibonacci sequence but it is accepted as an important level in the indicator as it represents halfway retracement of the price move. 0.786 is the square root of 0.618.

Whenever stock moves upwards or downwards sharply, it often retraces before continuing its journey. As we can see in the above image, the sharp up move began at 3245.32 and extended up to 7468.46. In this case, the 100% Fibonacci move is 7468.46–3245.32 = 4223.14.

How are the support levels calculated? Let us understand with an example :

In the above chart, we saw that the 100% move is 4223.14 points. To calculate the price value of 0.382 we carry out the following calculation :

Calculating 38.2% retracement of the absolute value (100%) of the prior move. — 4223.14 x 0.382 = 1613.24

Now we will subtract the 38.2% value from the reversal point i.e 7468.46–7468.46–1613.24 = 5855.22. This value can be verified in the chart above.

If the 1st support at 23.6% is broken, the next support comes at 38.2%. Similarly, if the 38.2% level is breached, the next support comes at 50% and so on.

How to draw Fibonacci retracement ?

We will take an example of a bullish impulsive move and draw Fibonacci retracement :

Step 1: Identify the trough and peak of the move. The trough is the lowest point in the entire move i.e the point where the impulsive move began. The peak is the highest point in the entire move i.e the point from where the price started to retrace.

Image 2: Trough & Peak

Step 2: On Streak, right-click on the chart and open drawing tools. In the drawing tools, select the options as marked in the image below:

Image3: Drawing tool & watchlist as seen on Streak.world

Step 3: Using the Fibonacci Retracement tool, connect the trough and peak beginning from the trough.

Image 4: Fibonacci Retracement levels

The same steps will be followed in case of a downtrend but instead of beginning at the trough, the drawing will be from peak to trough as shown in the image below:

Image 5: Fibonacci Retracement levels for a downtrend

How to use Fibonacci Retracement for trading?

If a stock had moved sharply and quickly and a chance to enter was missed, the retracement levels provide a good opportunity to enter the trade after the price has retraced.

Like other indicators, Fibonacci levels should not be used alone. One must look for other confirmations like the formation of candlestick patterns at these levels, volume spike, prior consolidation at the same level, etc.

Conclusion:

Fibonacci retracement indicator finds its origin in the Fibonacci series. The indicator is used to spot potential support levels from where the price can bounce after a sharp move retraces. Other confirmations must be looked at before initiating a trade using the indicator.