Fibonacci Retracements and Ratios in Trading Stocks
Author: James Clark
Everything You Need to Know About Fibonacci Retracements and Ratios in Trading Stocks
Fibonacci retracements are popular tools technical traders use to identify possible support and resistance levels. If you trade actively, you might have observed that prices trail some specific patterns. If you look deeper using a Fibonacci retracement analysis, you’ll find that it is among the best ways to forecast price goals.
Read on to learn more!
What is the Fibonacci Sequence?
The Fibonacci sequence is a number series where the next number is the addition of the two former numbers, beginning with 0 and 1. The most remarkable characteristic of this sequence is that each number is approximately 1.618 times greater than the last. It is as follows:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233….
What are Fibonacci Ratios?
A Fibonacci ratio is a common relationship between every number in a given series. It serves as the foundation traders use to determine retracement levels.
The key Fibonacci ratio is 61.8%. You can calculate it by dividing any number in the series by the number that follows it.
The second ratio is 38.2%. You can calculate it by dividing any number in the series by the number located two steps to its right.
Lastly, we have a 23.6% ratio. You can calculate it by dividing any number in the series by the number located three steps to the right.
What are Fibonacci Retracements?
A Fibonacci retracement is a popular stock trading examination tool that uses the percentages and horizontal lines on a price chart to help traders predict future potential price resistance and support levels in the markets. Using this tool, they can decide when to open and close a position or stop or limit their trades.
How the Fibonacci Retracement Tool Works
A sample Fibonacci Retracement graph
Here’s how the Fibonacci Retracement tool works:
The tool displays Fibonacci retracements by first drawing a trend line between the two extreme points on the price chart.
It draws six horizontal lines intersecting the trend line at all the Fibonacci ratios: 0.0%. 23.6%, 38.2%, 50%, 61.8%, and 100%.
Applying these percentages to the difference between the high and low price for a specific period creates different price objectives, depending on the market direction (up or down).
Pros and Cons of Fibonacci Retracement
If you’re a beginner, you should know that the tool has some disadvantages despite its popularity. Its use is highly subjective as traders who make profits using it find it effective, and those who lose money claim that it’s highly unreliable. Perhaps the main concern is that its underlying principle is a numerical anomaly that doesn’t offer any logical proof regarding the price changes.
However, many traders ignore the rationale behind this mathematical strategy and instead use target levels as confirmation indicators used in synchrony with various technical indicators, like moving averages and momentum.
Fibonacci retracements are great for confirming suspicions of a market movement. However, they require a high level of understanding to be used effectively. Experienced traders can find success using this tool to place transactions with long-term price trends.
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