What is Fibonacci Retracement?
Fibonacci Retracements help identify areas (i.e. price ranges) in a stock chart from where the stock’s price could reverse.
If a stock that has been constantly appreciating starts falling, it can be expected to rebound once it reaches this range. These retracement zones are identified using Fibonacci trading ratios.
For example, one of the key ratios used in Fibonacci analysis is 50%. When a stock falls by 50% from its peak value after continuously increasing, it can be expected to stop falling and bounce back.
The strength of this bounce back is determined by the retracement level. If the stock falls by more than 50% and reaches the next Fibonacci ratio, the pullback may be greater.
Using Fibonacci in stock market analysis
You can use retracement ratios to spot bullish and bearish trends and act accordingly. When a stock starts declining after a period of appreciation, it has the tendency to rebound (appreciate again) upon reaching one of the Fibonacci levels, such as 50%.
You can perform a deeper technical analysis when it approaches a retracement level and buy it if you feel a rebound is likely.
The stock in the chart below rallied from Rs.19.45 to Rs.29.55 before retracing by almost 50% (44.6% to be exact) to reach Rs.25.05. The trend reversed at this point and the stock appreciated again to Rs.29.00. You could have made a profit of 16% had you identified the retracement using Fibonacci.
Fibonnaci Retracement for Stock Trading
Fibonacci trading works similarly for declining stocks. When a stock starts appreciating after a period of decline, it has the tendency to rebound (fall again) upon reaching a retracement level.
If you bought the stock when it was falling, you are already making a profit. You can perform a deeper technical analysis when it approaches a retracement level to see if the rebound is probable. If you think it is probable, you can sell the stock and protect your profit.
Key Fibonacci ratios
Fibonacci analysis involves four key ratios: 23.6%, 38.2%, 50%, and 61.8%.
They are based on the work of Italian mathematician Leonardo Pisano Bogollo. Bogollo introduced the Fibonacci sequence, which is a sequence of numbers that extends to infinity and has some unique properties. The sequence goes as follows:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987……
Notice that after 0 and 1, each number in the series is the sum of the previous two numbers. For example, 1+2=3, 2+3=5, 5+8=13 and so on.
The other unique attributes of the Fibonacci sequence are:
Dividing any number by the previous one gives approximately 1.618. For example, 55/34=1.6176, 89/55=1.6182, 144/89=1.6180, and 233/144=1.6181.
Dividing any number by the next one gives approximately 0.618 or 8%. For example, 34/55=0.6182, 55/89=0.6179. 89/144=0.6181, and 144/233=0.6180.
Dividing any number by the one that is two places higher gives approximately 0.3820 or 2%. For example, 13/34=0.382, 21/55=0.3818, 34/89=0.3820, and 55/144=0.3819.
Dividing any number by the one that is two places higher gives approximately 0.2360 or 6%. For example, 13/55=0.2363, 21/89=0.2359, 34/144=0.2361, and 55/233=0.2361.
These attributes give three of the four key Fibonacci Retracement ratios: 23.6%, 38.2%, and 61.8%. The 50% retracement ratio comes from the Dow Theory and not the Fibonacci sequence. The Dow Theory's assertion that the averages often retrace half their prior move.
What do Fibonacci Retracement levels mean?
Each retracement ratio used in Fibonacci analysis indicates the depth of the retracement, i.e. the strength of the reverse momentum. The probability of a long-term price reversal trend increases as we move up the sequence of ratios.
A 23.6% retracement (i.e. when a stock’s price rises / falls by 23.6% of its recent high / low) is considered “shallow” because it is mostly followed by a short pullback. It is not enough reason to bet on a big stock price reversal.
38.2% and 50% retracements increase the probability of a big price reversal, but they too don’t confirm it. These retracements are called “moderate” retracements. Even when prices retrace by 61.8%, a price reversal trend is not confirmed.