Fibonacci Retracement: Meaning, How To Use, Importance and Limitation

The world of mathematics is filled with magical concepts, numbers, and patterns, but nothing yet comes close to the Fibonacci series. Long ago, in ancient India, between 450 and 200 BCE, mathematician Acharya Virahanka discovered the Fibonacci numbers. Later, in 600 A.D., their interesting sequencing was discovered. The knowledge was passed on to other mathematical scholars. Leonardo Pisano Bigollo, an Italian affectionately known as Fibonacci, introduced the series to the Western world, and hence it was named after him. 

The concept can be observed in nature, too, where spiral patterns of sunflowers, pinecones and seashells often adhere to the Fibonacci ratios! This has led to the concept being incorporated into various art forms, such as music and dance, to create rhythm and balance. 

Fascinating! Isn’t it? 

The concept is as useful as it is fascinating. It finds extensive application in the world of technical analysis and is used to identify price movements, reversals, retracements and more. 

This article talks about the application of Fibonacci in technical analysis and how it is an important tool for traders.

What Is the Fibonacci Series?

The Fibonacci sequence is a mathematical concept which is frequently applied in stock market analysis. It helps to pinpoint potential levels where prices might find support or resistance, predict future price movements, and examine patterns in market trends.

Starting with 0 and 1, each number in the sequence is the sum of the two preceding ones. According to these computations, here’s what the sequence looks like: 0, 1, 1, 2, 3, 5, 8, 13, 21, ……. 

The key Fibonacci ratios are also derived from this sequence. These ratios are used extensively for technical analysis in trading and aid in making strategic decisions. The primary Fibonacci ratios include 61.8%, 38.2%, and 23.6%.

But how do we get these ratios? The first ratio, 61.8%, is derived by dividing a number in the sequence by the one immediately following it. For instance, take 13 and 21; dividing 13 by 21 gives roughly 61.9%. A similar calculation with 3 and 5 yields about 60%. While these ratios aren't exact, they align closely with Fibonacci principles.

Interestingly, the 61.8% ratio is also known as the golden ratio (0.618 or 1.618) because it is a proportion observed in various natural phenomena, such as the structure of human DNA and the patterns of galaxies.

Looking further, the sequence reveals that dividing a number by the number which is two places ahead approximates 38.2%. For example, dividing 5 by 13, or 13 by 34, results in a figure close to 38.2%.

Similarly, if you divide a number by another three places ahead in the sequence, you'll get a ratio near 23.6%. For instance, 8 divided by 34, or 5 by 21, yields ratios around 23.6%.

In addition to these core ratios, Fibonacci analysis might also incorporate 50%, 78.6%, and 100% to chart and analyse price trends alongside other notable ratios, including 14.6%, 76.4%, and 85.4%. This offers traders better tools to interpret and predict market movements.

What Are Fibonacci Retracements?

The Fibonacci retracement is an extension of the above-explained concept and is used to identify potential levels of support and resistance. The word ‘retracement’ here, means minor corrections or changes in trend. The underlying idea is that after a significant price move, a stock or market often retraces a portion of the move before continuing in the original direction. 

Now, Fibonacci retracement levels are derived from the Fibonacci series and are represented by horizontal lines on a price chart. The most commonly used Fibonacci retracement levels are 38.2%, 50% and 61.8%. 

To understand how the retracements happen, let’s take a simple example. Consider stock A is currently priced at ₹70 and experiences a surge to ₹120. To determine the retracement levels, you will calculate the vertical distance between high and low price values. You will then multiply the difference with the ratios. If it is an uptrend, like in this case, you will subtract the derived value from the high point price (and vice versa in a downtrend).

Take a look at this table below –

Stock name	High Point	Low Point	Difference	38.2%	50%	61.8%
Stock A	₹120	₹70	₹50	19.1	25	30.9

So, at 38.2%, stock A’s retracement level could be = 120-19.1 = 100.9

At 50%, stock A’s retracement level could be = 120- 25= 95

At 61.8%, stock A’s retracement level could be = 120- 30.9= 89.1

These computed levels are then horizontally plotted on a chart and serve as potential support and resistance zones. Traders may consider entering long or short positions based on the asset’s price movement if it retraces and reaches one of these identified levels.  

How To Use Fibonacci Retracements in Trading?

Now that you understand the Fibonacci series and retracement, the next question you may have is this – How do you apply this when trading? Well, here are some steps you can take to use the Fibonacci retracement concept in trading. 

1. Identify a significant price move: Start by identifying a clear and substantial price move in the chart. This could be a recent high swing or downtrend.
2. Draw Fibonacci retracement levels: Using a charting platform, draw Fibonacci retracement levels by connecting the high and low points of the identified price move. You may use the most common retracement levels - 38.2%, 50% and 61.8%. 
3. Analyse price action at retracement levels: Observe how the price responds when it approaches a certain retracement level. Look for signs of support or resistance, such as price reversals, consolidation, or significant volume rise. 
4. Combine with other technical tools: To increase the reliability of your analysis, consider incorporating other technical tools. For example, you can use trendlines to confirm the overall trend direction or maybe a moving average to identify areas of support or resistance. It may be unwise to rely solely on one technical indicator or tool, no matter what past data says, whether it is Fibonacci or any other concept. 
5. Set entry and exit points: Now, based on the information gathered from Fibonacci retracement and other technical tools, determine your entry and exit points. This could involve setting buy or sell orders near the Fibonacci retracement levels or waiting for confirmation of additional candlestick patterns or indicators. 

Significance of Fibonacci Retracements

For various reasons, the Fibonacci series has always been a subject of interest for market analysts. As explained above and supported by past studies, the Fibonacci series finds high significance in identifying potential support and resistance levels. Traders often use Fibonacci retracement levels to define entry and exit points and generate buy and sell signals. 

They can also be used to identify areas of price expansion beyond the existing trend. By doing so, traders can identify levels where a stock may encounter resistance or support, which can also help place stop losses and target prices. 

Furthermore, the Fibonacci series finds application in other market theories, such as the Dow and Elliott Wave theories. The Elliott Wave Theory that we discussed in the previous chapter is based on the idea that market movements follow repetitive patterns. It incorporates Fibonacci ratios to determine the magnitude and duration of market waves. This can help traders anticipate trend reversals or continuations. So, by using Fibonacci ratios along with other technical indicators, traders can navigate markets with greater success. 

Besides stock markets, the Fibonacci series continues to find practical applications across different fields, including computer algorithms, coding, artificial intelligence, financial modelling and data analysis. 

Limitations of Fibonacci Retracements

The legend of Fibonacci and its applicability are widely known. But, like most other technical indicators, this concept is not devoid of limitations.  Below are some limitations:

1. Lack of Guarantees: Stock prices do not always retrace to Fibonacci levels. This means that there's no certainty in their predictive power. Thus, it cannot provide guarantees about future market movements.
2. Overemphasis on Mathematics: The series assumes that market movements are primarily driven by mathematical patterns and ratios and this might not always hold. Markets are influenced by various factors, including economic indicators, geopolitical events, and investor sentiment. Extensive dependence on the Fibonacci series might lead to overlooking these critical factors. 
3. Assumption of Repetitive Patterns: The fundamental assumption within the Fibonacci framework is that past market patterns will recur in the future. Since markets evolve continually, relying solely on historical data may not be wise. 
4. Subjectivity in Interpretation: The interpretation of Fibonacci levels can vary significantly among traders. This may lead to diverse analyses and predictions. This introduces inconsistencies and potential inaccuracies in trading decisions.
5. Vulnerability to Market Anomalies: The Fibonacci series might not effectively account for the impact of market fluctuations. Sudden events can disrupt expected patterns and make predictions based on the Fibonacci series less reliable.

Concluding this chapter, let’s dive into our next, discussing an important market parameter – Volume. We shall also study the different volume indicators and their importance.