Stock prices fluctuate daily. They will often form trends in one direction or another and then bounce back against those trends. Moves in a trending direction are called "impulses," and moves against a trend are called "pullbacks." Fibonacci retracement levels highlight areas where a pullback can reverse and head back in the trending direction. That makes them a useful tool for investors to use to confirm trend-trading entry points.
- Fibonacci retracement levels highlight areas where a pullback can reverse and head back in the trending direction.
- These four numbers are the Fibonacci retracement levels: 76.4, 61.8, 38.2, and 23.6.
- While useful, Fibonacci levels will not always pinpoint exact market turning points.
Origins of Fibonacci Levels
Fibonacci levels are derived from a number series that Italian mathematician Leonardo of Pisa—also known as Fibonacci—introduced to the west during the 13th century. The sequence starts like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89...
Each new number is the sum of the two numbers before it. As the sequence progresses, each number is approximately 61.8% of the next number, approximately 38.2% of the following number, and approximately 23.6% of the number after that. Subtract 23.6 from 100, and the result is 76.4.
These four numbers are the Fibonacci retracement levels: 76.4, 61.8, 38.2, and 23.6.
The Relevance of the Sequence
What Fibonacci and scholars before him discovered is that this sequence is prevalent in nature in spiral shapes such as seashells, flowers, and even constellations. As a spiral grows outward, it does so at roughly the same rate as the percentages derived from the Fibonacci ratios.
Some believe that these ratios extend beyond shapes in nature and actually predict human behavior. The thinking goes, essentially, that people start to become uncomfortable with trends that cause changes to happen too rapidly and adjust their behavior to slow or reverse them.
According to this theory, if someone started out with $100 in their wallet, they would begin to slow their spending—or stop altogether—once they had spent about $61.80 and have only about $38.20 remaining.
Fibonacci Retracement Levels in the Stock Market
When a stock is trending very strongly in one direction, the belief is that the pullback will amount to one of the percentages included within the Fibonacci retracement levels: 23.6%, 38.2%, 61.8%, or 76.4%. Some models also include 50%.
For example, if a stock jumps from $10 to $11, the pullback is likely to be approximately 23 cents, 38 cents, 50 cents, 62 cents, or 76 cents (the above percentages applied to a dollar).
Early or late in trends, when a price is still gaining or losing steam, it is more typical to see retracements of a higher percentage.
In this image, you'll notice that between 61.8% and 38.2% there are two downward trends. This is an example of a Fibonacci retracement. The theory states that it is typical for stocks to trend in this manner, because human behavior inherently follows the sequence.
How to Use Fibonacci Retracement Levels
If your day trading strategy provides a short-sell signal in that price region, the Fibonacci level helps confirm the signal. The Fibonacci levels also point out price areas where you should be on high alert for trading opportunities. In the above scenario, for example, if you see the stock drop 38 cents from $11 to $10.62, you can note that it's a Fibonacci number. That may be a good opportunity to buy, knowing that the stock will likely bounce back up.
Using a Fibonacci retracement tool is subjective. There are multiple price swings during a trading day, so not everyone will be connecting the same two points. The two points that you connect might not be the two points others connect. To compensate, draw retracement levels on all significant price waves, noting where there is a cluster of Fibonacci levels. That may indicate a price area of high importance.
While useful, Fibonacci levels will not always pinpoint exact market turning points. They provide an estimated entry area but not an exact entry point. There is no guarantee that the price will stop and reverse at a particular Fibonacci level or at any of them.
If the price retraces 100% of the last price wave, that may mean the trend has failed. Further, if you use the Fibonacci retracement tool on very small price moves, it might not provide much insight. The levels will be so close together that almost every price level appears important.
Fibonacci retracements provide some areas of interest to watch on pullbacks. They can act as confirmation if you get a trade signal in the area of a Fibonacci level. Play around with Fibonacci retracement levels, apply them to your charts, and incorporate them if you find that they help your trading.