The Fibonacci retracement is a technical analysis tool that traders often use to determine support and resistance levels.
This definition may sound complicated, but truth be told, appearances can be deceiving. The answers can be found in this article for those of you looking to know more about Fibonacci retracements.
Support outlines the level at which an asset's price stops falling and bounces back up. Resistance defines the moment at which the price usually stops going up and drops back down.
The importance of Fibonacci retracement levels
Expanding your trading know-how is an excellent thing to do because the markets are generous and never fail to offer exciting investing options. According to Wikipedia, Fibonacci retracements are among the crucial techniques people learn when delving into trading.
As we have already explained, Fibonacci’s utility is to define support and resistance trendlines. Based on a numerical sequence, you will be able to draw horizontal lines (retracements) representing potential levels for placing orders such as take profit or stop loss.
Support and resistance levels can determine the balance between demand and supply and buyers/sellers in the markets. When the number of buyers topples the number of sellers (or the demand is higher than the supply), prices are expected to rise. When the sellers are more numerous (the supply is higher than the demand), prices tend to fall.
The Fibonacci sequence is a series of numbers where, after 0 and 1, every number is the sum of the two previous numbers. It was discovered by the famous mathematician Leonardo Fibonacci in the 13th century.
The Fibonacci sequence looks like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597…
Now here comes the exciting part. Each number is roughly 61.8% of the next number, roughly 38.2% of the following number, and roughly 23.6% of the number after that. If we subtract 23.6 from 100, the result is 76.4.
In technical analysis theory, the numbers 76.4, 61.8, 38.2, and 23.6 represent the Fibonacci retracement levels. In some cases, the number 50 is also present.
How is the Fibonacci sequence used in trading?
Because Fibonacci retracements help traders spot trend reversals (changes in the asset price direction), they can be useful for determining entry points*. From then on, retracements can point out stop-loss orders and price targets suitable for different market conditions.
*Entry points represents the price at which an investor buys or sells a security.
The retracement levels depend on the previous market movements. So, after a significant price jump (called Swing High), traders measure the move from bottom to top to find where the price could retrace before bouncing higher and resuming its climb.
Following a significant price drop (Swing Low), traders measure the move from top to bottom to find where the price could retrace before falling further and continuing the downwards trend.
Fibonacci retracements shortcomings
Fibonacci retracements are very subjective, so different types of traders employ them in different ways. Just take a minute to think about it: with the number of price swings happening every day, which ones are you going to use as a barometer for retracements? There's no right or wrong answer: it's all a matter of strategy, experience, and intuition.
Also, Fibonacci retracements cannot identify the perfect entry points, as they indicate mere estimates of when it could potentially be useful to open a position.
Fibonacci retracements can be handy risk management tools for traders of all levels. They can help you determine your risk versus reward ratio before entering each trade. You can also use Fibonacci retracements as a powerful management tool for uncovering new levels of support and resistance.
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Sources: babypips.com, investopedia.com, wikipedia.com
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