Fibonacci retracements

Fibonacci retracements refer to areas of support or resistance levels calculated by using the Fibonacci sequence. A central concept here is what’s called the Golden Ratio, which refers to 1.618 and it’s inverse .618. The Italian mathematician, Leonardo Fibonacci (1170-1250), is credited for bringing the sequence to the West. Using the sequence, Fibonacci noticed that certain ratios could be calculated, and that these correspond to “divine ratios” found throughout nature, architecture and art. To learn more, watch the video or continue reading below:

The Sequence and Ratios

For trading purposes, it’s sufficient to introduce the basic idea behind the Fibonacci sequence:

The Golden Ratio

The sequence extends to infinity and starts as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610……

After 0 and 1, each number is the sum of the two prior numbers, i.e. 0+1=1, 1+1=2, 1+2=3, 2+3=5, 5+8=13, 8+13=21, 13+21=34, 21+34=55 etc. The Fibonacci sequence contains many unique mathematical properties:

    • If a number is divided by the previous number it approximates 1.618 (21/13=1.6153, 34/21=1.6190, 55/34=1.6176, 89/55=1.6181). The higher the numbers, the closer one will get to 1.6180.
    • If a number is divided by the next highest number, it approximates .6180 (13/21=.6190, 21/34=.6176, 34/55=.6181, 55/89=.6179 etc….). The higher the numbers, the closer one will get to .6180. This is the basis for the 61.8% retracement.
    • If a number is divided by another two places higher, it approximates .3820 (13/34=.3823, 21/55=.3818, 34/89=.3820, 55/=144=3819 etc….). The higher the numbers, the closer one will get to .3820. This is the basis for the 38.2% retracement. Also, 1 – .618 = .382 (!).
  • If a number is divided by another three places higher, it approximates .2360 (13/55=.2363, 21/89=.2359, 34/144=.2361, 55/233=.2360 etc….). The higher the numbers, the closer one will get to .2360. This is the basis for the 23.6% retracement.

Fibonacci retracements and extensions

Fibonacci levels are used to identify potential reversal and extension scenarios. Following a strong uptrend, the levels are used to predict the extent of a pullback. The same can be done during a downtrend, i.e. evaluating how far a counter-trend bounce may retrace. The Fibonacci levels from the current day are found by measuring the distance between the day high / low and dividing the vertical distance by the key Fibonacci ratios. The most commonly used retracement levels are 38.2% and 61.8%. Although the 50% retracement is not part of the Fibonacci sequence, it is almost always included as a point of reference (half the range).

Fibonacci retracements from current day

Fibs from current day – retracement levels

Fibonacci extensions are calculated when a move retraces more than 100% of its prior high/low (breakout). By applying the vertical distance from the prior high low and adding one of the key Fibonacci ratios to the prior high / low, one may locate target areas. For example, one may use the -138.2% level as a target for a breakout to the downside. Conversely, the 138.2% extension can be used as a target for a breakout to the upside. Of course, Fibonacci extensions only come into play once the market is setting new highs or lows, and when there’s a lack of other clear support resistance levels.

Fibonacci extension levels

Fibs from prior day – extension levels

Validating Fibonacci Setups

Fibonacci retracements and extensions should be combined with other indicators and price action scenarios. One option is using Volume Spread Analysis to identify imbalances between supply and demand. Generally, climax and churn bars can be used to identify when a pullback or bounce is likely to have run it’s course. We have created a short tutorial video on how to identify those scenarios using Bloodhound from Shark Indicators.

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