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The Fibonacci Retracement: Definition, Applications, Calculations, and More


What is Fibonacci Retracement: In the vast presence of nature, a unique pattern can often be observed from the minute of atoms to flowers to even the huge spirals in the galaxies. Astonishingly, this pattern can even be found in the stock market.

This pattern is commonly referred to as the Fibonacci sequence, named after Leonardo Fibonacci who discovered this sequence. This pattern is commonly used in the stock market during retracements of securities.

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In this article, we shall understanding what is fibonacci retracement, how to calculate and how to use fibonacci retracement.

Understanding Fibonacci Sequence 

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Developed by Leonardo Fibonacci in the 13th century, the Fibonacci sequence is a series of numbers starting with zero and one which gradually increases with each number equal to the sum of the two numbers before it.

Therefore, the sequence will be as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 and so on, which will extend to infinity. Here, each number is approximately 1.618 times greater than its previous number. The value 1.618 is also referred to as the golden ratio.

Understanding Golden Ratio

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The value 1.6818 is referred to as the ‘Golden Ratio” or Phi. This value is derived by selecting any number in the Fibonacci sequence and dividing it by the number before it.

This value often mysteriously appears in the natural world, fine art, architecture and biology. For instance, this ratio has been noticed in the painting of Mona Lisa, in sunflowers, tree branches, human faces, rose petals and even the spiral galaxies of outer space.

This ratio can also be extensively used in Fibonacci Trading

Let us now proceed to the concept of how to use Fibonacci Retracement

What are Retracements in Trading?

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Retracements are movements in the opposite direction of the stock price’s existing movement. These are temporary movements and do not indicate the wider trend in the market.

What are Fibonacci Retracement Levels?

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Fibonacci retracement levels, derived from the Fibonacci sequence, are horizontal lines that indicate where support and resistance are expected to occur. These levels will appear using the Fibonacci retracement tool by connecting the highest and the lowest point in the security

Each level is represented by a percentage. The percentage represents the measurement of the price correction or pullback in relation to the prior trend. 

The Fibonacci levels of retracement are 23.6%, 38.2%, 61.8%, and 78.6%. While not an official Fibonacci ratio, 50% is also used as a level of Fibonacci retracement.

These levels are useful as they can help us identify the level where a security might resume to move in its initial trend.

How are Fibonacci Retracements Levels Calculated

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The calculation of Fibonacci retracement is simply a percentage of the range between the high price and the low price of a security.

The percentages in the Fibonacci retracement are derived by dividing any value from the Fibonacci sequence with the values towards its right.

When you divide any one value from the Fibonacci sequence by the next, the result will be equal to 61.8% or 0.618. 

When you divide the same value by the second value towards its right, the result will be equal to 38.2% or 0.382. 

All the values in Fibonacci retracement are based on the same mathematical calculations employed on the Fibonacci sequence, except for the value 50% or 0.5.

How To Use Fibonacci Retracement

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Fibonacci Retracement can be used by traders to draw support levels, identify resistance levels, place stop-loss orders, and set target prices. Let us now understand how to use Fibonacci Retracement in an uptrend and a downtrend

How to use Fibonacci Retracement in an Uptrend

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Following are the steps to be followed how to use Fibonacci retracement in an Uptrend:

  1. Identify the Uptrend:

When the price of the security is making higher highs for a significant duration, you use the Fibonacci retracement tool, as the security tends to understand price retracement during any trend.

  1. Apply Fibonacci Retracement Levels:

Connect the low point and the high point of the security using the Fibonacci retracement tool. This will give you the different levels of Fibonacci retracement.

  1. Entry Point:

When the price of the security retraces to one of the Fibonacci levels, one can consider entering a long position in the security. Traders may look for additional confirmation signals, such as candlestick patterns or indicators, to confirm the entry.

  1. Profit Target

One can consider booking profits from the trade when the price of the security reaches the high point from where the price had retraced.

  1. Stop Loss

One can place a stop-loss a few points below the Fibonacci level from where the trade has been entered.

What are Fibonacci Retracement - Uptrend Image
(Source: Tradingview)

How to use Fibonacci Retracement in a Downtrend

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Following are the steps to be followed How to use Fibonacci retracement in a Downtrend:

  1. Identify the Downtrend:

When the price of the security is making lower lows for a significant duration, you use the Fibonacci retracement tool, as the security tends to retrace during any trend.

  1. Apply Fibonacci Retracement Levels:

When the price of the security retraces from the downtrend, identify the high and the low price to the point of its retracement. Connect the high point and the low point of the security using the Fibonacci retracement tool. This will give you the different levels of Fibonacci retracement.

  1. Entry Point:

When the price of the security retraces to one of the Fibonacci levels, one can consider entering a short position in the security. Just like in the uptrend, traders can look for additional confirmation signals to confirm the entry.

  1. Profit Target

One can consider booking profits from the trade when the price of the security reaches the low point from where the price had retraced.

  1. Stop Loss

One can place a stop-loss a few points above the Fibonacci level from where the trade has been entered.

Fibonacci Retracement - Downtrend Image
(Source: Tradingview)

How much should a security retrace?

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If the security retraces up to 50% on the Fibonacci scale after a significant uptrend or a downtrend, it is considered that the primary trend is still intact and the price will likely reverse in that direction

A security retracing up to 61.8% on the Fibonacci scale indicates that the primary is weakening and the price may likely move against it.

In Closing

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As we conclude our article on what is Fibonacci retracement, it is important to remember that, while these levels can serve as potential places of support or resistance, they do not ensure a trend reversal or continuation.

Thus, it is always important for traders to use appropriate risk management strategies which include placing a stop-loss order to protect against adverse price movements and analysing the overall market conditions before entering a trade.

Written By – Aaron Vas

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