Fibonacci Retracement

Fibonacci retracement is quite a popular analytical tool in technical analysis, the key principles of which are based on the Fibonacci Numbers (identified by mathematician Leonardo Fibonacci in the thirteenth century). Technical analysts do not use Fibonacci numbers directly, but rather the ratio between numbers in the series. As a rule, Fibonacci Retracement is drawn through the major top and the major bottom of a stock (index, or any other tradable commodity) chart and by dividing the distance between these two points by the ratios of 23.6%, 38.2%, 50%, 61.8% and 76.4%.

The Fibonacci lines at the ratio levels are used in technical analysis to predict possible support and resistance levels. The technical analysts assume that the price of a stock moves in cycles. In most cases, these cycles (also known as "waves") are caused by psychological factors, such as a desire to fix profit at certain levels, and cut losses at specific points, etc. For unknown reasons, the analysts assume that emotions and psychology of traders (as for many things in the nature) follow a specific pattern where Fibonacci Numbers play a critical role. Thus, when the price moves to the line drawn at the Fibonacci ratio level, a stock is considered to be vulnerable to a change in its trend and the 61.8% ratio is considered as a key ratio (also known as "the golden ratio") in this analysis. The analysis of historical price movements shows that, after a significant price movement, the new support and resistance levels occurs in many cases at or near Fibonacci lines.

Fibonacci Retracement alone could be used to define where to open a trade, to identify a target price and to locate a stop-loss level. At the same time, the retracement lines are used in Elliot Wave analysis, in Tirone Levels, and in the Gartfley Patterns, etc.

The NASDAQ 100 chart below illustrates how a price trend changes its direction at Fibonacci Retracement levels.

Chart 1: NASDAQ 100 chart with Fibonacci Retracement

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