What is Fibonacci Retracement in Trading?

Many beginners struggle with timing entries and exits. They purchase stocks at the wrong time because they lack the knowledge of predicting when they will rise or fall.

However, introduced in the 13th century by Leonardo of Pisa, the Fibonacci Retracement (FIB) can show the levels where market momentum may stop, reverse, or continue, by giving you more assurance. Let us understand what is fibonacci retracement, how it works, and its calculation.

What is FIB Retracement?

The Fibonacci retracement is a common technical analysis tool that can help you identify potential price levels where an asset’s upward or downward trend may stall or reverse. These levels depend on the Fibonacci sequence, which is a set of numbers like – 0, 1, 1, 2, 3, 5…, where each number is determined by adding the two numbers preceding it.

Certain percentage levels are 23.6%, 38.2%, 50%, 61.8%, and 78.6%. These are drawn between two price points, a high and a low, on price charts. These serve as possible reversal zones in price movements and are referred to as Fibonacci retracement levels.

You frequently reach close to 1.618 when you divide a number in the series by the one preceding it. This is the ‘Golden Ratio’, which appears frequently in the natural world, from the forms of flowers to the appearance of galaxies. This ratio, which is around 61.8%, is frequently expressed as a percentage in trading.

What Do You Mean by Fibonacci Retracement Levels?

Fibonacci retracement levels can help you find possible support and resistance levels in financial markets. The Fibonacci series, a mathematical series in which each number is the sum of the two numbers before it, is the source of these levels. These levels also help in the following ways:

1. Finding Possible Reversals

   Fibonacci retracement levels indicate potential trend reversals, resistance, or support regions. These levels are computed as percentages of a prior price movement.

2. Versatility

   You can see Fibonacci numbers in many natural patterns and in mathematics for centuries. You may also use them for any significant price fluctuation, such as a high-to-low or a low-to-high movement.

3. Indian Origin

   Although Fibonacci numbers are often associated with the West, they were first created and utilised as early as 200 BC by Indian mathematicians, such as Acarya Virahanka.

4. Cautionary Use

   Although useful, it is important not to rely only on Fibonacci retracement. For a thorough examination, you should consider price movement and other technical indicators.

How to Calculate Fibonacci Retracement Levels?

Now that you understand the Fibonacci retracement meaning, you must use the calculation to move forward. Here is the step-by-step process:

1. Determine the highest high and lowest low of a recent price movement.
2. Calculate the price difference by subtracting the low price from the high price.
3. Multiply the price difference by the desired Fibonacci percentage, like 23.6%, 38.2%, 61.8%, 78.6%, and others.
4. Subtract the result from the high price to find the potential support level in an uptrend, and add the result to the low price to find the potential resistance level in a downtrend.

Uptrend retracement = High price – (price difference × Fibonacci percentage)

Downtrend retracement = Low price + (price difference × Fibonacci percentage)

How to Utilise Fibonacci Retracement in Trading?

The use of Fibonacci retracement for trading is simple. Analytical traders have the option to hold off until a certain stock corrects itself and reaches a steady selling price. A trader must consider the figures of 23.6%, 38.2%, and 61.8% before settling on a specific price to purchase or acquire stocks, taking into account market volatility.

You have to select only two spots between the price ranges of a stock’s highs and lows. The graph is then drawn with lines at percentages of Fibonacci retracement numbers.

For example, if a stock price has moved from INR 100 to INR 125, then Fibonacci retracement levels will be:

• 23.6% = INR 119.1
• 38.2% = INR 115.45
• 50% = INR 112.5
• 61.8% = INR 109.55
• 78.6% = INR 105.35

These levels can help you estimate where price corrections might halt or reverse, providing you with a strategic advantage.

When the price reaches a Fibonacci level, it may reverse its trend. You can use these levels to set their stop-loss and take-profit orders. Moreover, you can identify potential entry and exit points with this  Fibonacci retracement.

If you want more assistance in trading, you can download the PL Capital Group – Prabhudas Lilladher application. PL offers you key market trends and real-time stock alerts.

Benefits of Using Fibonacci Retracement

1. Accuracy

   With the correct price setting, Fibonacci retracement can help you determine accurate price reversal moments at early levels. Additionally, it helps you confirm a change in the trend direction later.

2. Convenience

   You can use this tool on any assets at any market and in different timeframes. However, you must remember that if the timeframe goes higher, the signals become more accurate.

3. Highly Visual

   Most of the technical indicators depend on a formula that shows the previous patterns. Fibonacci levels take the help of a mathematical algorithm and the majority’s psychology. This can be more helpful while building a Fibonacci trading system.

Limitations of Using Fibonacci Retracement

Besides benefits, the Fibonacci retracement also has some limitations, which are:

1. Subjectivity

   Since different traders have different choices of swing highs and lows, it can be difficult to focus on a trend’s accurate high and low points, especially in sideways markets.

2. Incompatibility

   Since it is a discretionary method, expert advisors cannot directly include Fibonacci retracement.

3. Misleading Signals

   This tool can also produce misleading signals when the price cannot reach or reverse at the expected Fibonacci levels.

Why Should Traders Use Fibonacci Retracements?

Traders use this Fibonacci retracement to mainly understand the psychological elements of trading with mathematical trading. This tool also allows you to make better judgments while entering trades during pullbacks in key retracement levels and to put stop-loss orders beyond the next retracement level for risk management.

Additionally, Fibonacci retracement also helps to use confluence zones where the levels are in line with trendlines or moving averages. It can also help you to time your trading decisions more confidently in both an uptrend and a downtrend.

Final Thought

Fibonacci retracement combines both ancient mathematics and the current world’s market psychology. Both a beginner and an experienced investor can sharpen their strategies using this Fibonacci retracement.

While it is convenient and highly visual, the Fibonacci retracement levels are also subjective and can provide misleading signals.

You can also use the PL Capital application to get stock recommendations and learn about trading signals. PL also allows you to open a Demat account for free.

Frequently Asked Questions

1. What is the golden rule for using Fibonacci retracement?

The golden rule of using Fibonacci retracement is to identify a proper price movement and use any tool to draw Fibonacci lines. Then, you must interpret the retracement levels and anticipate the movements in the market.

2. Is Fibonacci retracement an effective strategy?

Yes, the Fibonacci retracement is an effective strategy as it is simple to use and helps you understand price action. To make it more effective, you should combine it with other strategies.

3. How to use a Fibonacci retracement indicator?

You can use the Fibonacci retracement indicator by marking the swing high and low on a chart. Then you must observe the levels for possible price reversals.

4. What is the best time for using Fibonacci retracement?

There is no ideal timeframe for using Fibonacci retracement, since it is a flexible analysis tool. While swing traders use daily or weekly charts to find the support and resistance levels, day traders consider shorter timeframes like hourly charts.