Fibonacci retracement is a type of technical indicator that traders use to determine the support and resistance levels for a stock price.
The well-known Fibonacci sequence of numbers, where each number is the sum of the two previous numbers, is important to how this technical analysis tool works owing to the relationship between the numbers in the series.
These ratios, expressed as a percentage, capture how much a stock price has retraced with its recent movement. The most important Fibonacci retracement levels are: 23.6% 38.2%, 50%, and 61.8%, 78.6%, and they are applied as horizontal lines on a stock chart.
Traders can use these retracement levels to mark high and low points that may offer signals that a price is going to stall out or reverse.
What Are Fibonacci Retracement Levels?
Fibonacci retracement levels are based on the Fibonacci series where each number equals the sum of the two previous numbers. The most basic series is: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, etc.
The relationship between these numbers has created the retracement levels commonly used by traders: 23.6% 38.2%, 50%, and 61.8%, 78.6%.
For example, each number is approximately 1.618 times greater than the preceding one. As a result, some analysts refer to 61.8% as “the golden ratio,” because it roughly equals the division of one number in the series by the number that follows it. For example: 13/21 = 0.6190, and 21/34 = 0.6176, and 34/55 = 0.6181
In fact, there are similar relationships to be found between other numbers in the series, and these have become the ratios used by technical traders to determine retracement levels in stock prices. For example, dividing a number in the series by the number three places to its right roughly equals 23.6%.
Note that 50% is somewhat of an exception to the rule: It’s not mathematically part of the Fibonacci-derived number set, but traders have nonetheless found it useful when gauging support and resistance levels.
Who Created Fibonacci Numbers?
The Fibonacci sequence is based on the work of a 13th-century mathematician Leonardo Pisano Bigollo, nicknamed Fibonacci. While Fibonacci was not the first to identify this series, he transformed mathematics in the West thanks to his introduction of the Hindu-Arabic system of numbers, a place-value system.
The Hindu-Arabic system, which we use today, replaced Roman numerals and the complex calculations that required.
In 1202, Fibonacci published Liber Abaci (“Book of Calculations”) to introduce Hindu-Arabic numerals. The Fibonacci series was included here, but the observation of this pattern had been identified and worked with for hundreds of years before, in India. Over time, its pattern has been observed in everything from the spiral of seeds in sunflowers to spirals in the double helix of DNA.
Because the Fibonacci sequence occurs frequently in various natural and mathematical contexts, it has been adopted for a number of uses, including as a technical analysis tool for stock traders. That said, the reason for the common occurrence of these numbers in contexts or applications that are unrelated, is not well understood.
How Does Fibonacci Retracement Work
Fibonacci retracement levels are not based on an exact formula that gets applied to the stock price movements. Rather, traders identify two static price points for analysis, e.g., a high and a low, and apply the retracement levels from the Fibonacci sequence to determine support and resistance levels.
If a stock price movement retraces a prior move, ending on a point that is represented by a Fibonacci number, it could indicate that a reversal is in store.
The use of Fibonacci ratios as a technical indicator is somewhat subjective, however, since the underlying numbers are a part of a mathematical pattern. They aren’t inherently related to stock prices or market movements.
For example, if a stock price rises to $20 from $15, a trader might set the retracement levels at 23.6% and 50%. Those would be, respectively: $18.82 ($20 – ($5 x 0.236) = $18.82) and $17.50 ($20 – ($5 x 0.50) = $17.50).
If the stock price retraced from $20 down to one of those levels, it could signal a reversal. But Fibonacci retracements can also be used to gauge the strength of an uptrend, by noting the support and resistance in relation to the retracement levels.
Support and Resistance
Support is the price level that acts as a floor, preventing the price from being pushed lower, while resistance is the high level that the price reaches over time. Analysts often illustrate these as horizontal lines on a graph.
A support or resistance level can also represent a pivot point, or point from which prices have a tendency to reverse if they bounce (in the case of support) or retreat (in the case of resistance) from that level.
Learn more: Support and Resistance: What Is It? How to Use It for Trading
What Does a Fibonacci Retracement Do?
Markets don’t go straight up or down. There are pauses and corrections along the way. Traders can use these retracements to find optimal prices at which to enter a trade. For example, if a stock moves up, but then retraces to the 61.8% level before moving higher again, that might be a signal to buy.
Why? Because the price retraced to a Fibonacci level during an uptrend. A trader could also use that retracement point to set a stop-loss order at the 61.8% level (remember, that’s the boundary of the price retracement, not the price itself). If the price drops down below that level, the rally may be a bust.
In other words, the Fibonacci retracement levels, while static, help to indicate potential inflection points where a stock might see a break or a reversal.
What Is a Fibonacci Extension?
As discussed, Fibonacci retracements may help indicate a price reversal. Fibonacci extensions apply the same logic to price moves in an upward trend.
With a Fibonacci extension, the trader uses three points to assess whether the price will continue on its trend. The first two points are similar to those used for a Fibonacci retracement: the trader picks two price points, a start and an end (e.g. a high and a low). The third point is the retracement level, which sets up the potential extension (if there is one).
Some of the key ratios used to calculate Fibonacci extensions are 61.8%, 100%, 161.8%, 200%, and 261.8%.
Limitations of Fibonacci Retracement
Fibonacci retracements may indicate potential price movements, especially when employed by experienced traders who are familiar with the application of this particular indicator. But over-relying on them can be counterproductive:
• Fibonacci retracements, like other indicators, are most informative when paired with at least one other technical analysis tool, such as moving averages.
• The use of Fibonacci retracement levels and extensions is generally a subjective endeavor. Although the numbers themselves do occur in a range of contexts in the natural world and in mathematics, there is no objectively tested rationale for how or when to use the Fibonacci numbers with stock prices.
• Fibonacci retracement sequences are often close to each other, therefore it may be tough to accurately predict future price movements.
Fibonacci Retracements and Trading
Traders typically use Fibonacci retracement levels to help anticipate price reversals, to set entry and exit points for trade, to create stop-loss orders, and more.
• Trend prediction. Fibonacci retracements have been known to predict the price reversals of a stock at early stages.
• Flexibility. Fibonacci retracement works for assets in any market and any time frame. Longer time frames could result in a more accurate signal.
• Gauge of market psychology. Fibonacci levels are built on both a set of mathematical calculations and the psychology of the market. Combined, these may convey a fair assessment of market sentiment.
The Takeaway
The Fibonacci retracement technical indicator can help identify hidden levels of support and resistance so that analysts may be able to better time their trades. The Fibonacci retracement levels are derived from the well-known mathematical phenomenon known as the Fibonacci sequence: a series where each number is the sum of the previous two numbers.
From this sequence, mathematicians dating back centuries were able to derive ratios based on the relationship between one number and another in the series. What makes these ratios significant is that they recur in a range of contexts, from the natural world to the stock market.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
FAQ
How accurate is Fibonacci retracement?
Fibonacci retracement levels can be useful for traders, although no indicator is perfect and they are best used in combination with other technical indicators. The accuracy levels often increase with longer time frames. For example, a 50% retracement on a weekly chart is a more important technical level than a 50% retracement on a five-minute chart.
What are the advantages of using Fibonacci retracement?
Fibonacci retracement is relatively easy to apply to any price chart. It’s not a formula, but a set of measurements that may help traders assess the importance of certain price movements and trends. When an experienced trader uses the Fibonacci ratios in combination with other technical indicators, it may be possible to set entry and exit points for trades and anticipate reversals.
What are the disadvantages of using Fibonacci retracement levels?
Although it’s well established that the Fibonacci numbers occur in plants, in galaxies, and in stock market movements, it’s not well understood why that is. Therefore, the use of the Fibonacci retracement levels tends to be subjective. For that reason, it may be more effective in combination with other indicators that can help confirm price trend analysis.
Photo credit: iStock/HAKINMHAN
SoFi Invest® INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
SOIN-Q224-1915692-V1