Do you know the Fibonacci Retracement definition? With technical trading, we need to know where we can expect to see support and resistance levels. Fibonacci retracements are horizontal lines indicating where levels of support and resistance will likely occur. The levels stem from a Fibonacci sequence, which is a mathematical formula that originated in the 13th century. This is also known as the Golden Ratio.
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How Does the Fibonacci Retracement Work?
Each Fibonacci level has an associated percentage. This percentage is related to how much the prior price movement retraced. The levels of retracement are 23.6%, 38.2%, 61.8%, and 78.6%. Some will use a 50% retracement level as well (though not a classic Fibonacci).
The indicator is useful because it can easily be drawn between two significant price points (i.e., a high and low). Then the indicator will automatically draw the levels between those two points.
A stock that rises $100 and then drops $23.60 will have retraced 23.6%, our first Fibonacci number. This Golden Ratio is seen in nature, and many traders believe the numbers have financial market relevance. Support and resistance is so important in trading. Therefore, it’s good to know the Fibonacci retracement definition.
Finding the Fibonacci Retracement Definition Levels
There’s no difficult formula to find the Fibonacci levels except to take the levels and find the percentage difference between two chosen points. In essence, that’s the Fibonacci Retracement definition. When the indicator is applied, you will choose the 2 points, and the lines will be drawn at the Fibonacci percentages of those two lines.
If a price moves from $100 to $150, and we chose these levels as our endpoints, the retracements for the 23.6% level is:
$150 – ($50 * 0.236)= $138.20
The 50% level is:
$150 – ($50 * 0.5)= $125.00
We can find the rest of the levels by substituting the retrace percentages with the last number before the equals sign.
So where did these retracements come from? They’re found using the golden ratio. If you start a sequence of numbers from zero then one and then keep adding the prior two numbers together you will get the following string of numbers:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987… continuing indefinitely
Our retracement levels are obtained using this string of numbers. Starting with 34 dividing any number by the number to its right will result in 0.618 (if we use 34 we mean 55), and two numbers to its right (89) is .382. Note that 50% isn’t in this list, it’s not a true Fibonacci. This is why it’s important to know the Fibonacci Retracement definition.
The 0.618 Golden Ratio can be found in nature (see above photo). As well as manmade structures (see below photo).
How Do We Use Fibonacci Retracements for Trading??
There are several uses for Fibonacci retracements; we can place entry orders, use them as stop-loss levels, and set price targets. If you see a stock moving higher and it then retraces to the 61.8% level and starts to climb again, you can put in a buy order for the current price and set your stop loss at that 61.8% level.
If it falls below the Fibonacci level again, it is a failed rally. Fibonacci lines are found in other technical analyses such as Elliott Wave Theory and Gartley patterns. Both of these technical analyses show that after large movements, reversals happen near the defined Fibonacci levels.
Because the Fibonacci levels are static (unlike a moving average), they’re easy to identify. You can then react prudently when a price level is reached/tested. The levels are an inflection point where price action will likely occur and can reverse or break.
This is hopefully helpful in learning the Fibonacci Retracement definition.
The Difference Between Retracements vs. Extensions
Fibonacci retracements will use percentages to determine a pullback; however, Fibonacci extensions will apply the ratios to a move in a trending direction. Say a stock moves from $100 down to $75; this is a retracement; however, an extension is if it then rallies up to $161.8.
The Limitations of Fibonacci Retracement
The retracements are predictions of where there may be support and resistance, but there is no guarantee this will happen. Other confirmation signals should be incorporated into a strategy that uses Fibonacci retracements. There are also so many levels that a reversal is likely to happen eventually, and therefore, it is hard to determine which retracement level will see the turn.
The Fibonacci Retracement definition isn’t hard to understand. Fibonacci retracements can be incorporated into your trading to better make decisions for entry and exit points. The full list of points used by Fibonacci adherents is:
23.6%, 38.2%, 50% 61.8%, 78.6%, 100%, 161.8%, 261.8%, and 423.6%
These are the levels we would expect a price to stall or reverse. While these levels can be used to help with trade decision making they should not be used exclusively. As always, never risk with one trade more than you are willing to lose, and good luck with all of your trades.