Fibonacci Retracements

What is a Fibonacci Retracements?

A Fibonacci retracements is a term used in technical analysis that refers to areas of support or resistance. Use horizontal lines to show where support and resistance levels are feasible. Each level is associated with a percentage. The percentage is how much of a prior move the price has retraced. The Fibonacci retracement levels are 23.6%, 38.2%, 61.8% and 78.6%. While not officially a Fibonacci ratio, 50% is also used.

To fully understand the concept of Fibonacci retracements, you must understand the Fibonacci series. 

The Fibonacci series is a sequence of numbers starting from zero arranged in such a way that the value of any number in the series is the sum of the previous two numbers.

The Fibonacci sequence is as follows:

0,1, 1, 2, 3, 5, 8, 13, 21, 34,  55, 89, 144, 233, 377, 610…

Notice the following

5 = 2+3 
8 = 3 + 5 
13 = 5 +8.  
This series extends to infinity.

There are few interesting properties of the Fibonacci series.

Divide any number in the series by the previous number; the ratio is always approximately 1.618.

For example

233/144 = 1.618
144/89 = 1.618

89/55 = 1.618

The ratio of 1.618 is considered as the Golden Ratio, also referred to as the Phi. Fibonacci numbers have their connection to nature.

Further into the ratio properties, one can find remarkable consistency when a number is in the Fibonacci series is divided by its immediate succeeding number.

For example:

89/144 = 0.618
144/233 = 0.618

377/610 = 0.618

At this stage, do bear in mind that 0.618, when expressed in percentage is 61.8%.

Similar consistency can be found when any number in the Fibonacci series is divided by a number two places higher.

For example:

13/34 = 0.382
21/55 = 0.382

34/89 = 0.382

0.382 when expressed in percentage terms is 38.2%

Also, there is consistency when a number in the Fibonacci series is divided by a number 3 place higher.

For example

13/55 = 0.236
21/89 = 0.236
34/144 = 0.236

55/233 = 0.236

0.236 when expressed in percentage terms is 23.6%.

Relevance to stocks markets

It is believed that the Fibonacci ratios i.e 61.8%, 38.2%, and 23.6% finds its application in stock charts. Fibonacci analysis can be applied when there is a noticeable up-move or down-move in prices.  Whenever the stock moves either upwards or downwards sharply, it usually tends to retrace back before its next move.

‘The retracement level forecast’ is a technique using which one can identify upto which level retracement can happen. These retracement levels provide a good opportunity for the traders to enter new positions in the direction of the trend.  The Fibonacci ratios i.e 61.8%, 38.2%, and 23.6% helps the trader to identify the possible extent of the retracement. The trader can use these levels to position himself for trade.

Have a look at the chart below:

I’ve encircled two points on the chart, at Rs.380 where the stock started its rally and at Rs.489, where the stock prices peaked.

I would now define the move of 109 (380 – 489) as the Fibonacci upmove.  As per the Fibonacci retracement theory, after the upmove one can anticipate a correction in the stock to last up to the Fibonacci ratios. For example, the first level up to which the stock can correct could be 23.6%. If this stock continues to correct further, the trader can watch out for the 38.2% and 61.8% levels.

Notice in the example shown below, the stock has retraced up to 61.8%, which coincides with 421.9, before it resumed the rally.

Here is another example where the chart has rallied from Rs.288 to Rs.338. Therefore 50 points move makes up for the Fibonacci upmove. The stock retraced back 38.2% to Rs.319 before resuming its up move.

The Fibonacci retracements can also be applied to stocks that are falling, in order to identify levels upto which the stock can bounce back. In the chart below the stock started to decline from Rs.187 to Rs. 120.6 thus making 67 points as the Fibonacci down move.

After the down move, the stock attempted to bounce back retracing back to Rs.162, which is the 61.8% Fibonacci retracement level.

Here is another example where the chart has rallied from Rs.15 to Rs.31. Therefore 16 points move makes up for the Fibonacci upmove. The stock retraced back 50% to Rs.23 before resuming its up move.

How should you use the Fibonacci retracement levels?

Think of a situation where you wanted to buy a particular stock but you have not been able to do so because of a sharp run up in the stock. In such a situation the most prudent action to take would be to wait for a retracement in the stock. Fibonacci retracement levels such as 61.8%, 38.2%, and 23.6% act as a potential level upto which a stock can correct.

By plotting the Fibonacci retracement levels the trader can identify these retracement levels, and therefore position himself for an opportunity to enter the trade. However please note like any indicator, use the Fibonacci retracement as a confirmation tool.

I would buy a stock only after it has passed the other checklist items. In other words my conviction to buy would be higher if the stock has:

    1.   Formed a recognizable candlestick pattern

    2.   The stoploss coincides with the S&R level

    3.   Volumes are above average

Along with the above points, if the stoploss also coincides with the Fibonacci level then I know the trade setup is well aligned to all the variables and hence I would go in for a strong buy. The usage of the word ‘strong’ just indicates the level of conviction in the trade set up. The more confirming factors we use to study the trend and reversal, more robust is the signal. The same logic can also be applied for the short trade.