What is Fibonacci Retracement? How to Use it to Enter or Exit a Trade?

Ganesh Adhikari

Fibonacci retracement, a technical indicator for stock analysis is well-favored by traders and investors. Fibonacci retracements consist of horizontal lines which identify the possible support and resistance levels that help the traders to place stop-loss orders, set target prices, and make potential buys. Fibonacci retracements can be drawn between any two points (usually a peak and a trough) for determining support and resistance levels for the two points.

Fibonacci retracements are based on Fibonacci sequence (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144….).

You May Also Like:

5 Best Trading Strategies for Stock Traders

Head & Shoulder’s Pattern: How to Identify Trend Reversal While Trading?

What is the Fibonacci Sequence? Why are Fibonacci Retracements Highly Rated?

Each number in the Fibonacci sequence is the sum of the two numbers that precede it. The Fibonacci sequence was first discovered or invented by the Italian mathematician, Leonardo Fibonacci in the 13th century.

The most appealing thing about the series is the ratio: 1.618, also known as golden ratio or golden section φ (Phi), which is frequently observed in nature. The golden ratio is obtained when any number is divided by its previous number in the series.

Fibonacci sequence in nature: golden ratio is found almost everywhere in the universe and nature. The spiral shape of the snail is formed by the golden ratio. The Fibonacci sequence is observed in the spirals formed by seeds of sunflower also in spirals of cauliflowers, broccoli, and pinecones. Even the arrangement of leaves and petals on plants exhibit a golden spiral. Moreover, the golden ratio exists in human anatomy or the natural expansion of billions of galaxies.

Sometimes the golden ratio obtained from the Fibonacci series is referred to as the “nature’s secret code,” or “nature’s universal rule.”

Thus it is no wonder Fibonacci retracements are so valued in the capital market as well, helping traders to estimate the possible trend with surreal consistency.

Calculating Fibonacci Retracement Levels

There are different levels in Fibonacci retracement which are created by dividing the vertical distance between the extreme points in the charts by the key Fibonacci ratios: 23.6%, 38.2%, 50%, 61.8%, and 100%.

These ratios are simply obtained by dividing any number in the Fibonacci series by the number following it in different positions. For example: 21 divided by 34 equals to 0.618 (i.e. 61.8%), 13 divided by 34 equals to 0.382 (i.e. 38.2%) and 8 divided by 34 is 0.236 (i.e. 23.6%).

Fibonacci Retracements for Appropriate Entry and Exit

Fibonacci retracements are often used to make the low-risk entries in the existing strong trend by identifying the pullback and the support level. The indicator has different levels that show the possibility of bouncing back, it is up to the traders to best anticipate the bounce back retracement level for entry.

As the Fibonacci retracements don’t predict the bounce-back position(only shows possible outcome), it is wise to use other technical indicators such as RSI (relative Strength Indicator), MACD (Moving average convergence divergence), candlestick patterns, moving averages, trend lines volume confirmation. Engulfing twins in a candlestick pattern is a very effective confirmation of the Fibonacci retracement level. The chances of bounce back or reversal are high when Fibonacci levels confluence with these technical analysis indicators. The more the confirmation pattern coincides, the better the chances for a robust reversal signal.

Use of Stop-loss with Fibonacci Retracements:

As mentioned earlier, Fibonacci retracement doesn’t confirm or predict trend change or market momentum. So stop-loss becomes very essential while using the technical indicator tool. Stop-loss can be placed at a point below the retracement level where you placed your buy order where your analysis looks like it might have gone the wrong way.

Target price: Exiting the market at the right point is very essential to book huge profits. Exiting too early or too late both causes more or less similar financial hazards. If you exit too early you might be booking a small profit, then it’s a lost cause. The chances for making huge profits come rarely and must be taken with both hands when the opportunity is presented. The best exit position can never be identified using Fibonacci retracement levels alone as in entry positions. The sell signal should be confirmed with other momentum oscillators or candlestick patterns.

Also Read:

How to Use Candlestick Chart to Buy/Sell Stocks?

Bollinger Bands Trading Strategy: Explained

Elliott Wave Theory and Fibonacci Retracements

In technical analysis, Elliot wave theory is used to analyze the market trends and forecast the market movements owing to changes in investors’ psychology. The fluctuations in the long-term price pattern are described as waves. Those making trades to profit from these short-term market trends are compared to riding a wave. The principle was developed by Ralph Nelson Elliot (1871–1948), a professional accountant in the 1930s.

Fibonacci retracements usage is supported by Elliot wave theory. The fact that Fibonacci retracements are used to find the possible support and resistance levels between any two extreme points, is supported by the psychology of the traders whose sentiments are saturated at a point of riding the wave of the market in the particular direction and tend to be pulled back.

Relative Strength Index (RSI): How It Signals Buy/Sell Decision in Stock Trading

Cons of Using Fibonacci Retracements (Limitations)

Fibonacci retracements levels don’t provide any assurance for the prices to bounce back at any level. It must be confirmed with other technical indicators.
Since there are many retracement levels between two points, it is hard to identify which level the indicator is going to respect and bounce back eventually. At different points in time, the pullback occurs at different Fibonacci retracement levels.

Conclusion

No one knows why Fibonacci retracements work so well with uncanny accuracy. Just like the presence of the Fibonacci sequence and its golden ratio in nature is majestic, it works magic in the stock market.

The effectiveness and power of Fibonacci retracement are multiplied when combined with other technical indicators. A trader can use the volatility of the market to his/her advantage and make healthy financial gains with the help of this technical tool by identifying appropriate buy and sell signals. Further, this tool can be applied better when the long-term trend is identified first and one is confident about the bounce back.

Every type of trader (swing traders, pullback traders, scalp traders, etc.) or long-term investors can use Fibonacci retracements to take advantage of the market’s short-term momentum. Indeed, Fibonacci retracements have stood the test of time and proved to give an edge to the technical analysts in the capital market.

From The Author:

Technical Analysis: Basics, Charts & Major Indicators

7 Best Risk Management Strategies for Traders

(Liked this article??? If you are also interested in publishing your articles related to business, finance, and economics, then mail us your article at Investopaper@gmail.com.)