Do you know what a Fibonacci retracement is?

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A Fibonacci retracement is a technical indicator commonly used in trading to indicate the price support and resistance levels of a financial unit (e.g. a stock). It’s a term you probably read often in our chartist articles from Gary Stone or Lance Lai.

In order to define the Fibonacci retracement in simple terms, we must first understand the concepts of ‘Fibonacci’ and ‘retracement’.

The word ‘Fibonacci’ might take you back to high school maths. In case you need a reminder, a Fibonacci number is found by adding the two preceding numbers in the sequence, e.g. 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 etc. (i.e. 0+1 = 1; 1+1 = 2, and so on). The approximate ratio between Fibonacci numbers is 1.618, aka Φ (Phi) or the ‘Golden Ratio’ – e.g. 55 x 1.618 = 89.

This is a sequence that occurs in nature – and as such, some mathematicians argue that the stock market (driven by the natural resource that is the human mind) is likely to follow a Fibonacci pattern.

Moving along, a retracement is a temporary movement in a share price, which goes against the general trend, but is not indicative of a price reversal. For instance, if a share’s price is generally heading upwards but dips slightly on a given day, it may be classed as a ‘retracement’ rather than an all-out change in price direction.

So combining these two concepts, we can understand the Fibonacci retracement as different price levels between which a share will fall, in percentage terms. As Gary Stone wrote in his recent article for the Switzer Super Report, prices never rise or fall in a straight line. There is always some level of retracement, and often (but not always) these retracement brackets follow a Fibonacci sequence. The Fibonacci retracement levels most commonly referred to by traders are 0%, 23.6%, 38.2%, 50%, 61.8%, 76.4% and 100%.

When a stock price crosses a “support” (price stops going lower) or “resistance” (price stops going higher) level, it graduates to the next Fibonacci bracket – this movement is referred to as ‘Fibonacci retracement’. The graph below maps these main Fibonacci retracement levels.

Source: Online Trading Concepts

This indicator is commonly used by traders to predict opportune times to buy or sell a share. For instance, if a stock is reaching its support level, you may be able to buy it at good value before it heads back up. When there is a significant price change, traders will adjust the Fibonacci support and resistance levels of a stock (i.e. it will move into the next ‘price bracket’). An investor might elect to put a “stop loss” in place at a Fibonacci retracement level or just below it.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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