Last Updated: Feb 20, 2023 Value Broking 8 Mins 2.8K

The Fibonacci retracement strategy stems from the Fibonacci series. A Fibonacci series is a sequence where the next number is the sum of its preceding two numbers. 

The Fibonacci Series

A Fibonacci sequence generally starts with 0 and 1, but you can make a Fibonacci series by using any two starting numbers. The most known Fibonacci series is 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144… and so on.

The word Fibonacci comes from the man who published the sequence, and his actual name is Leonardo da Pisa. Fibonacci numbers are the numbers that make up the sequence are more commonly used compared to the whole series. A specialty of Fibonacci numbers is that they’re seen very often in nature, including humans. A common way to find two Fibonacci numbers is to divide them. When a smaller number divides a significant number, they give a ratio. This ratio is a recurring number when you divide consecutive numbers in the whole sequence and is also called the Golden ratio. The Golden ratio is often visible in nature, architecture, music, art, etc.

The Fibonacci series is beneficial to the trading community as well. There’s a complete strategy known as the Fibonacci retracement strategy. It’s beneficial in a trend to understand support and resistance and continue the trend. Let us start by understanding what Fibonacci retracement is.

What are Fibonacci Retracement Levels?

Fibonacci retracement levels are horizontal lines that make up support and resistance lines. During an uptrend or a downtrend of the market, the retracement or the pullback is believed to be within these horizontal lines. The levels are 23.6%, 38.2%, 61.8%, or 76.4%. Even though 50 % isn’t part of the Fibonacci series, many Fibonacci retracement strategies utilize it. As the ratio is very prevalent, it’s also believed that humans have a natural tendency to follow it. This natural tendency is why the Fibonacci retracement plan is so widely used.

Numbers First Formulated in Ancient India:

  • Ancient India has a rich history of mathematical discoveries and contributions.
  • The development of numbers and numerical systems in ancient India was a significant achievement.
  • The ancient Indians formulated a numerical system based on the decimal system, which is still widely used today.
  • The decimal system is a positional notation system that uses ten as its base and represents numbers using a combination of digits from 0 to 9.
  • The concept of zero, as a placeholder, was also first developed in ancient India.
  • The ancient Indian mathematicians made important discoveries and advancements in arithmetic, algebra, and geometry.
  • They developed various algorithms and methods for calculations, including techniques for multiplication, division, and square root extraction.
  • The ancient Indian mathematician Aryabhata is credited with formulating the concept of zero and the decimal system in the 5th century CE.
  • Another renowned mathematician, Brahmagupta, further refined and formalized the decimal system and made significant contributions to algebraic equations.
  • These advancements in mathematics from ancient India had a profound influence on the development of mathematics in other parts of the world.

The Formula for Fibonacci Retracement Levels

With the help of the Fibonacci series, numbers used in the Fibonacci Retracement plan are derived. 

  • 0.236 is derived by dividing 13 by 55. The level used is 23.6 %
  • 0.382 is derived by dividing 13 by 14. The level used is 38.2%
  • 0.5 or 50% isn’t derived through the series but is more like a stable midpoint used in the Fibonacci retracement plan.
  • 0.618 is derived by dividing 13  by 21. The level here is 61.8%
  • 0.786 is derived by getting the square root of 0.618. The level used is 78.6
  • 0.886 is derived by finding the square foot of 0.7864. The level here is 88.6%

More and more levels can be derived based on the requirements. It’s pretty easy to create more levels by either dividing numbers in the series or getting the square root of these numbers.

How to Use Fibonacci Retracement?

Any chart can make use of these horizontal lines as and when you wish to use them. You select the tool and choose 2 points between draw levels. Here’s how you can make use of the Fibonacci Retracement tool. 

Pick Time Frame

It’s advisable to pick from a higher time frame and move lower, simply meaning one must choose a suitable time in the past, with the second choice being closer to the future.

Determining Reversal Zones

It’s essential to understand that you need a high and a low to use the Fibonacci retracement plan. It’s crucial to hence determine the reversal zones after a swing high or a swing low. Choosing the right breakpoints helps draw better and more useful horizontal lines. One must choose a suitable high and a suitable low instead of picking the 1st high and low they notice in a chart.

Drawing the Fibonacci Retracement Level

Once you choose your high and low and the time frame, you must now know how to use the tool to draw the levels.

  1. In an uptrend, one uses the upper value of the low point and the lower range of your high point. It gives you a realistic level that you can now use.
  2. In a downtrend, one must choose the upper range of your high point and the lower range of your low point for realistic levels.
  3. What Do Fibonacci Retracement Levels Tell You?

After drawing the levels, one can use this knowledge to base their trades on it. Say if you were trading in a share or a currency pair and it follows an uptrend and undergoes a reversal. You can now use the Fibonacci retracement plan to enter a trade. With the help of the Fibonacci retracement level, you can decide when to enter a trade and when to book profits. One of the levels will act as a support line. When this happens, you can enter a trade knowing that the above levels are resistant, and you can book profits once the price breaks through those levels.

Now, for example, say you choose to trade during a downtrend. You can take a short position after drawing the horizontal lines. One must realize that the upper lines act as support and lower lines are now resistant. One can take a short position or sell shares if they hold any at a support level. You can then sell the short position for a profit.

It’s how one can use the Fibonacci retracement plan to its fullest

Limitations of Using Fibonacci Retracement Levels:

Fibonacci retracement levels are a popular technical analysis tool used in financial markets to identify potential support and resistance levels.

While Fibonacci retracement levels can be useful, they also have certain limitations that traders should be aware of:

Subjectivity: The selection of the initial swing high and swing low points is subjective and can vary among traders. Different interpretations can lead to different Fibonacci retracement levels.

Lack of universal applicability: Fibonacci retracement levels work best in trending markets, but their effectiveness can be limited in choppy or sideways markets where price movements are less directional.

Over-reliance on a single tool: Relying solely on Fibonacci retracement levels without considering other technical indicators or factors can be risky. It is essential to use them in conjunction with other analysis tools for more robust decision-making.

Self-fulfilling prophecy: Fibonacci retracement levels have become widely known and used, which can result in a self-fulfilling prophecy. Traders may react to these levels simply because they are widely watched, potentially leading to a temporary distortion in price movements.

Limited predictive power: While Fibonacci retracement levels can provide potential support and resistance areas, they do not guarantee future price movements. Market dynamics are influenced by a multitude of factors, and relying solely on Fibonacci levels may not capture the full complexity of the market.

By considering these limitations and using Fibonacci retracement levels in conjunction with other technical analysis tools and fundamental factors, traders can make more informed trading decisions.

What is Fibonacci Retracement: Conclusion

One must understand that these horizontal lines will not always stand true. it’s impossible to be specific when the levels will be helpful and when they will fail. You can use it in whichever scenario they work in and not force levels on a chart if they don’t exist. Being dependent on only the Fibonacci retracement plan can be very harmful. One must utilize the array of tools and indicators available to make intelligent trading decisions yielding maximum profit.