What goes up comes down and what goes down comes up. Even in strong trends prices take temporary reversal or corrections quite frequently. It’s like taking the breathing time before moving ahead. But to what level?
Let's see what are Fibonacci numbers or Fibonacci sequence and how these are used in technical analysis before we discuss about Fibonacci retracements:
Fibonacci Fibonacci numbers is a series in which each number is the sum of the previous two numbers. The initial numbers of the series are as follows:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, ...,
You may check the above mentioned logic in this series i.e. 0+1 =1, 1+2=3, 2+3=5, 3+5=8 etc
Please also note the ratio of the numbers in this series:
21/34 = 0.618
13/34 = 0.382
8/34 = 0.236
You will see the same ratio if you take any subsequent numbers in the series e.g. 233 instead of 34 and the previous numbers i.e. 144, 89 and 55 instead of 34, 13 and 8.
These Fibonacci ratios can be found in nature, science, architecture, music, art. A few examples of these ratios can be found in pine cones, sunflowers, pineapples, palm trees, spider webs, snail shells, DNA molecules and millions of other things in the universe.
When applied on trading charts, Fibonacci Retracement Levels are used as support and resistance levels: 0.236 or 23.6%, 0.382 or 38.2%, 0.500 or 50.0%, 0.618 or 61.8% and so on. The most important retracement levels out of these are 38.2%, 50.0% and 61.8%.
It is argued that it was Indian mathematicians who were well aware of this series and ratios since 6th century but the western world was introduced to this series and it's occurrence in nature and life in 1202 through the book Liber Abce by Leonardo Pisano.
The common occurrence of Fibonacci ratios in the life made technical analysts explore the possibilities of these ratios to appear in the rapidly changing prices of commodities, stocks and then Forex also. We can always argue that there is nothing magical in these numbers or ratios to appear in the price movement but then we need to think why the technical analysis works. Most of the time it works because a large number of traders would be taking trading positions according to the signals generated. If a lots of long positions are taken then price would further increase. Similarly if large number of selling happens at a particular price level then price would further decline because of bearish pressure.
Fibonacci retracements are considered to be the levels to which the trending price would retrace when there is a slowdown in the trend. These retracement levels work best when there is a trend. Be it uptrend (bullish market) or downtrend (bearish market). Take an example of a person running fast for a long time. There will come a time when he or she will pause. Take a breath before resuming the running again. Similarly inn any strong trend, there are always some slowing down or corrections in the price movement before the trend continues once again.
During an uptrend when there is a slowing down of the price action and the price action starts going in the sideways mode is the first indication that some correction may take place.
Similarly during a downtrend when we see that the downward movement is slowing, and the market starts going is the first indication of a possible reversal or correction.
The above are the times that a pull back or retracement may take place. Fibonacci retracement come handy at such times as is clear by above two diagrams (charts 1 and 2). We will also see more examples as we go along this article.
When the pull back from the current direction (upwards or downwards) happen, it would be nice to know that to what level the reversal may take place. The three important levels of Fibonacci retracement levels are 0.382 (38.2%), 0.50 (50.0%) and 0.618 (61.8%) and many time we see the price corrections taking place to these levels.
Please refer the following charts:
In In the Forex chart 3 there is was a strong upward move from point "A" to point" B". The price action found resistance at point B and fell. Just see how perfectly there was a drop to exactly 38.2% level before moving up again?
Let's check the price movement in figures:
A = 1.4458
B = 1.5900
Hence total upward move was B – A = approx 1442 Pips
The price dropped to 1.5359 from point "B" i.e. 1.5900 - 1.5339 = 551 pips i.e. (551/1442)*100 = 38.21%
Please do not expect the retracements to be exactly to above mentioned ratios . But you will be surprised to find that how close the retracements would be to Fibonacci retracement levels.
When a reversal starts taking place we can enter the market in the direction opposite to the ongoing trend targeting the Fibonacci retracement levels as the profit taking targets.
When there is a continuous trend (up or down), wait till a reversal in the movement starts taking place. In this case we can wait till the price hits the Fibonacci retracement levels and enter the market in the direction of the ongoing trend. In very strong trends you may like to put orders considering small reversal i.e. at 0.382 (38.2%) level. When the momentum of the trend is not very strong then you can expect more reversal i.e. 0.50 or 0.618 (50 or 61.8%) levels or even more than these levels. The stop loss levels could be a little below the entry levels.
In the Forex chart 4, the upward move started from point A. The move took it to point B and then there was a pullback. Please see the small green candle encircled by the yellow circle. This green candle shows that during this period the price opened between retracement 38.2% and 50.0% levels and closed also between these two levels. But during this period it went down up to point X which is 50.0% retracement level and went up to point Y. During the next period (the bigger red candle) it went further down closer to 61.8% retracement level. During the next period (the still bigger green candle) the prices went and crossed 50.0% level and then moved up. It subsequently moved higher and higher towards point “C”.
The above two examples are of uptrend. The similar pull back can be seen during downtrends. When there is a downtrend, there would be pull backs to higher levels before further downward movement.
Please see the Forex chart 5 and the continued movement of the same in chart 6:
Please see the continuation of the movement in the chart 6. Chart 6 highlights the retracement upwards during this downtrend shown in chart 5 above. Please note the correction to 38.2% retracement level and to some extent towards 50.0% level.
Even if a trend continues there are always small correction and reversal on the way.
It’s just like that even if the runner is very strong and still full of energy; he or she would stop for taking a breath before continuing running further.
If it’s just a small breathing break, consider 38.2% as your retracement. But then you would find retracement to 50.0% quite common. In strong trends with big movement we can target 61.8% as retracement.
As mentioned above that we can use Fibonacci retracements levels in following two ways:
1) As profit targets opposite to the ongoing direction.
2) As entry points to take a position in the direction of the ongoing trend.
1.382, 1.50, 1.618 or 38.2%, 50% and 61.8% are the most important levels of Fibonacci extension. These extension levels are used as profit taking levels. Chart 9: Up Trend: Select Fibonacci retracement tool and join the bottom and top Points. The tool automatically draws dotted lines for 0.382, 0.50 and 0.618 or 38.2%, 50% and 61.8% levels. You will also find lines being drawn beyond the Top-to-Bottom (downtrend) or Bottom-to-Top (uptrend) range. These are Fibonacci Extension levels The above mentioned retracement and extension levels are most commonly used tools in technical analysis but you may also like to check other analysis tools like Fibonacci Arcs, Fibonacci Fans and Fibonacci Time Zones. We explained Fibonacci analysis in the context of forex trading but the same stands good for stock trading or any commodity trading. You may also use Fibonacci Pivot Point Calculator to calculate Fib pivot points and support and resistance levels. Check our daily updated Fibonacci support and resistance levels in Forex analysis page.
Fibonacci Pivot points can also be used to find likely supports and resistance levels.
Up Trend: Select Fibonacci retracement tool and join the bottom and top Points.
The tool automatically draws dotted lines for 0.382, 0.50 and 0.618 or 38.2%, 50% and 61.8% levels.
You will also find lines being drawn beyond the Top-to-Bottom (downtrend) or Bottom-to-Top (uptrend) range. These are Fibonacci Extension levelsThe Fibonacci retracements are shown in charts 1 to 9 above and chart 10 below.
The above mentioned retracement and extension levels are most commonly used tools in technical analysis but you may also like to check other analysis tools like Fibonacci Arcs, Fibonacci Fans and Fibonacci Time Zones.
We explained Fibonacci analysis in the context of forex trading but the same stands good for stock trading or any commodity trading.
You may also use Fibonacci Pivot Point Calculator to calculate Fib pivot points and support and resistance levels.
Check our daily updated Fibonacci support and resistance levels in Forex analysis page.