Do you know the Fibonacci Retracement definition? We need to know where to expect support and resistance levels with technical trading. Fibonacci retracements are horizontal lines indicating where support and resistance will likely occur. The levels stem from a Fibonacci sequence, a mathematical formula that originated in the 13th century. This is also known as the Golden Ratio.
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Fibonacci Retracement Definition
Each Fibonacci level has an associated percentage, which is related to how much the prior price movement retraced. Retracement levels are 23.6%, 38.2%, 61.8%, and 78.6%. Some will also use a 50% retracement level (though not a classic Fibonacci).
The indicator is useful because it can easily be drawn between two significant price points (e.g., a high and a low). The indicator will then automatically draw the levels between those two points.
A stock that rises $100 and 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 are so important in trading. Therefore, it’s good to know the Fibonacci retracement definition.
Fibonacci Retracement 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 are:
$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.
History
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. 50% isn’t on 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) and artificial structures (see below).
Using Fibonacci Retracements for Trading
Fibonacci retracements have several uses. We can place entry orders. Use them as stop-loss levels and set price targets. If you see a stock moving higher and then retrading to the 61.8% level and starting to climb again, you can put in a buy order for the current price and set your stop loss at that 61.8% level.
It is a failed rally if it falls below the Fibonacci level again. Fibonacci lines are found in other technical analyses, such as Elliott Wave Theory and Gartley patterns. These technical analyses show that reversals happen near the defined Fibonacci levels after large movements.
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.
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 to $75; this is a retracement; however, an extension is if it rallies to $161.8.
Limitations of Fibonacci Retracement
The retracements predict 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; therefore, it is hard to determine which retracement level will see the turn.
Fibonacci Retracement Considerations
Depending on the broker you use, the tool may plot the lines from low to high at 0 to 100 or plot the lines from low to high at 100 to 0. The picture below shows the lines showing
(from low to high) 0 to 100.
On TOS – I drew the lines starting at the top of the level and moving lower to end the drawing at the low end… and the 100 is at the top while 0 is at the bottom. But – if I use that same tool and start at the bottom and end at the top, we can see in the picture below that now the lines start at 100 at the bottom and end at 0 at the top.
The only thing I changed is where I started and ended the drawing. Some platforms will always draw lines moving higher from 0 to 100, some will always draw lines moving lower from 100 to 0, and some will allow us to decide.
Applying Fibonacci Levels
That brings us to the next point- where to actually apply the Fibonacci Retracement levels. Let’s zoom out on a daily chart and consider the very top and the very bottom and then let’s consider the ranges or pullbacks within that wide space.
If we were to apply the Fibonacci Retracement levels here from the highest and lowest points on the chart – we could measure that retracement to see how much pullback we took. This could give insight into the traders who got out (profit takers) and the new traders who took their place (new long traders). Typically – we do not want to see a retracement pullback further than 61.8%, but less of a pullback would be even better – stopping at 78.6%.
As we can see in the picture above, the price had a decent (and healthy) pullback that did not exceed the “expected” pullback range. If we had drawn the lines the other way (with 0 at the top and 100 at the bottom), the pullback would be between 23.6% and 38.2%.
We can also remove this Fibonacci Retracement and draw a new one on the pullback instead; that would give us a more narrowed focus toward the possible breakout above and the consideration of price rejecting the highs and pulling back again.
Final Thoughts
The Fibonacci Retracement definition isn’t hard to understand. Fibonacci retracements can be incorporated into your trading to decide entry and exit points better. 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%
Depending on the starting and ending point (and depending on the broker you use) the Fibonacci retracements can go from high to low (100 to 0) or from low to high (0 to 100) but we will still be looking for price to respond at these levels.
The Extension levels above 100 can also be added below 0 – if you have a broker that adjusts your fib drawings – consider adding negative -23.6%, -38.2%, and so on. This way – no matter which way you draw the Fibonacci retracements, there are extended lines beyond.
These are the levels at which we would expect a price to stall or reverse. While these levels can 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.
Frequently Asked Questions
A Fibonacci retracement shows how much the price has retraced to a prior move. It helps confirm a trend.
61.8 is considered a Golden Ratio because it's a number in the Fibonacci series divided by the number following it.
The most popular Fibonacci retracement levels are 23.6%, 38.2%, 61.8% and 78.6%.
The Fibonacci retracement is a good indicator of the stock staying within a trend and the extent of that trend. Then you know a good price target.
