What is Fibonacci retracement and how does it work in trading?

The Fibonacci retracement is a technical analysis tool widely used in trading and investing in financial markets.

Its most frequent use occurs following large movements that can arise from significant economic news or strong trends.

Those who invest and closely monitor the fluctuations of stocks, bonds, and currencies are certainly already familiar with this analytical method. However, if how it works, what it’s for, and why the Fibonacci retracement is important is still unclear, the following guide offers all the information you need to understand its application.

In general, it is a mathematical formula that lends itself to market assessments. There are numerous technical analysis indicators useful for forecasting price movements, but almost none can boast the widespread use, efficiency, and practicality of the Fibonacci retracement, a tool that should be part of every trader’s knowledge base for operating in the financial markets.

What is the Fibonacci Retracement

When trading, you often hear about Fibonacci retracements, named after a Pisan mathematician, Leonardo of Pisa, who lived in the 13th century and created the famous number series.

The Fibonacci sequence, also known as the golden sequence, in mathematics indicates a sequence of positive integers in which each number, starting with the third (2), is the sum of the two preceding ones. Thus, we have a series of numbers that begins like this:

1-1-2-3-5-8-13-21...

The unique characteristic of this series is the constant relationship between particular combinations of numbers that are part of the sequence. The ratio of two consecutive numbers in this series approaches 1.618 as the series approaches infinity.

This ratio, called the "Golden Mean," has been known since ancient times and has connections to other fields. In mathematics, Fibonacci numbers are somehow linked to the golden ratio, the Farey sequence, continued fractions, and even fractals. In physics, there is a connection with string theory, as well as in biology, music, economics, art, and even electrical engineering and computer science.

Fibonacci retracements, those used in technical analysis, are nothing more than percentage values (23.6%, 38.2%, 50%, 61.8%, 100%) that derive from the constant ratio between particular combinations of numbers in the sequence.

These are particularly significant levels and are carefully monitored by investors as they implement their strategic decisions. Of all the levels listed above, the 50% level is certainly the most important for trading purposes. However, the 38.2% and 61.8% retracement levels are also important for the reasons discussed below.

It should be noted that these retracement values are not intended to be insurmountable levels, but rather sensitive or psychological levels, at which a price reaction in financial markets is likely to be expected.

How does the Fibonacci retracement work?

The Fibonacci retracement is used after a strong price movement (bullish or bearish) to estimate where a temporary retracement might stop (i.e., a countermove before resuming the main trend).

Any trading platform allows for the automatic drawing of the various levels; the only requirement is to select the high and low marked by the dominant trend.

For this reason, Fibonacci retracements can follow an increasing or decreasing trend, depending on whether they originate from a dominant bullish or bearish trend, respectively.

If an upward movement is assumed to begin from a low (1) to a high (2), the Fibonacci tool’s range must be drawn within this range. Therefore, if one wishes to draw the retracement levels of an upward movement, the zero (0%) of the tool will be set at the high of the movement under consideration, while 100% will be set at the low.

Presumably for a downward movement, in this case the zero level of the instrument will be set at the low of the movement, while 100% will be set at the high. Thus, the 23.6% retracement level will be closest to current trading prices, while the 61.8% level will be furthest.

How to evaluate the trend using the Fibonacci retracement?

Once you have identified the movement on which to calculate the Fibonacci retracements and used the technical analysis tool available on all trading platforms to identify them, you can obtain the price levels associated with each of them.

The resulting price levels will therefore act as static support and resistance levels, although somewhat different from traditional ones, since they can often pass where there is no graphical market swing point. It’s important to consider that if a Fibonacci level also coincides with a static level, this confluence would simply represent a strengthening trend.

The magnitude of each corrective move is determined by how far the opposing price movement manages to move beyond certain Fibonacci retracement levels. All corrective moves tend to reach 23.6%. Breaking this level confirms the strength opposing the previous move.

The 38.2% level is considered crucial for trend continuation. Traders generally monitor this level closely for signs of strength or weakness, consistent with the previous trend. It’s important to keep in mind that in strong trends, corrective moves typically never exceed the 38.2% level.

The 50% level is the most important level to monitor. Typically, structurally sound trends are those in which corrective movements return to approximately halfway from the last directional impulse.

The 61.8% level is reached by strong corrective movements. Breaking this level is generally a strong sign of deterioration in the previously established trend.

Interpreting Fibonacci Levels

Once we have identified the dominant trend and plotted the Fibonacci retracements, we have obtained the price levels associated with each retracement, ready to represent support and resistance for the future trend.

The retracement of the dominant trend has very specific targets in the Fibonacci levels, which will determine its strength:

• retracement at 23.6: almost every retracement reaches this level, whose crossing indicates the presence of growing countertrend strength;

• Retracement at 38.2: Target following the breakout of 23.6, considered crucial for the continuation of the countertrend;
• Retracement at 50: Technical analysis benchmark outside the scope of Fibonacci but often considered by the market;
• Retracement at 61.8: Level reached by sustained countertrends in the market, whose strength has already allowed the market to break out of previous levels.

Trading with Fibonacci retracements means expecting the next target level to be reached after the previous one has been broken, thus opening positions in the intervals between each retracement.

This allows you to predict future price movements with a good degree of probability and trade with the retracement levels you expect to be reached.

Original article published on Money.it Italy. Original title: Cos’è il ritracciamento di Fibonacci e come funziona nel trading