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Understanding Fibonacci Retracement Levels in Technical Analysis

Fibonacci retracement levels—stemming from the Fibonacci sequence—are horizontal lines that indicate where support and resistance are likely to occur. These levels are significant in technical analysis for predicting potential price reversal points in the financial markets.

Key Takeaways:

• Fibonacci retracement levels connect any two points that the trader views as relevant, typically a high point and a low point.
• The percentage levels provided are areas where the price could stall or reverse.
• The most commonly used ratios include 23.6%, 38.2%, 50%, 61.8%, and 78.6%.
• These levels should not be relied on exclusively, so it is dangerous to assume that the price will reverse after hitting a specific Fibonacci level.
• Fibonacci numbers and sequencing were first used by Indian mathematicians centuries before Leonardo Fibonacci.

What Are Fibonacci Retracement Levels?
Fibonacci retracement levels are associated with percentages that indicate how much of a prior move the price has retraced. The key levels include 23.6%, 38.2%, 50%, 61.8%, and 78.6%. While 50% is not officially a Fibonacci ratio, it is commonly used.

Historical Origins:
Fibonacci retracement levels were named after Italian mathematician Leonardo Pisano Bigollo, famously known as Leonardo Fibonacci. However, Fibonacci did not create the Fibonacci sequence. Instead, he introduced these numbers to western Europe after learning about them from Indian merchants. Some scholars suggest Fibonacci retracement levels were formulated in ancient India between 700 BCE and 100 AD, while others estimate between 480-410 BCE.

The Formula for Fibonacci Retracement Levels:
Fibonacci retracement levels do not have specific formulas. When these indicators are applied to a chart, the user chooses two points, and the lines are drawn at percentages of that move. For example, if the price rises from $10 to $15, the 23.6% level will be at $13.82, and the 50% level will be at $12.50.

How to Calculate Fibonacci Retracement Levels:
Fibonacci retracement levels are simply percentages of whatever price range is chosen. They are based on the Fibonacci sequence:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987…

After the sequence gets going, dividing one number by the next yields 0.618, or 61.8%. Dividing a number by the second number to its right results in 0.382, or 38.2%. All the ratios, except for 50%, are based on some mathematical calculation involving this number string.

What Do Fibonacci Retracement Levels Tell You?
Fibonacci retracements can be used to place entry orders, determine stop-loss levels, or set price targets. For example, a trader may see a stock moving higher, retrace to the 61.8% level, and then start to go up again. Since the bounce occurred at a Fibonacci level, the trader might set a stop loss at the 61.8% level, as a return below that could indicate that the rally has failed.

Fibonacci Retracements vs. Fibonacci Extensions:
While Fibonacci retracements apply percentages to a pullback, Fibonacci extensions apply percentages to a move in the trending direction. For example, a stock goes from $5 to $10, then back to $7.50. The move from $10 to $7.50 is a retracement. If the price starts rallying again and goes to $16, that is an extension.

Limitations of Using Fibonacci Retracement Levels:
While the retracement levels indicate where the price might find support or resistance, there are no assurances that the price will actually stop there. This is why other confirmation signals are often used. The other argument against Fibonacci retracement levels is that there are so many of them that the price is likely to reverse near one of them quite often.

The Bottom Line:
Fibonacci retracements are useful tools that help traders identify support and resistance levels. With the information gathered, traders can place orders, identify stop-loss levels, and set price targets. Although Fibonacci retracements are useful, traders often use other indicators to make more accurate assessments of trends and make better trading decisions.

Reference from Investopedia

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