It’s fairly obvious that the stock market runs on a healthy dose of mathematics. After all, the goal jumping into the market in the first place is to add extra cash to existing funds over a period. If you want to extrapolate that into a mathematical formula, you may say your market goal is $ + stock x time = $$.
However, a fascinating mathematical element to the market is something that’s geeky and complex: The Fibonacci Retracement. This technical analysis term may sound pretty fancy, but for those that know how to utilize it properly, it can be a massive asset in helping them achieve the math-driven goal of turning an investment into a profit.
What are Fibonacci Retracements?
To get a bead on Fibonacci retracement, it’s important to know about the pattern known as the Fibonacci Sequence. Initially identified by Italian mathematician Leonardo Fibonacci in the 13th century, the sequence is used to demonstrate certain mathematical relationships or ratios that exist between numbers.
From a market perspective, the pattern behind the sequence is extrapolated to form the Fibonacci retracement, which is created by taking two extreme points on a stock chart – usually a major peak and a major trough – and splitting the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100%. Once investors pick out these levels, horizontal lines are drawn. These lines are used to spot potential levels of support and resistance within a given stock.
The Fibonacci ratios used in Fibonacci retracements link back to the numbers represented by the Fibonacci sequence, the first thirteen of which are: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, and 144. As the pattern demonstrates, the numbers in the sequence as they move forward are derived by adding the two previous numbers together. What makes this pattern works that each increase in number is about 1.618 times greater than the previous number. This relationship that exists between each number in the series builds common ratios, which can be reflected in the previously mentioned percentages.
For a rather mysterious reason, the ratios derived from the Fibonacci sequence have appeared to play a vital role in the stock market, in the sense that they can be used to pick out key points that cause the price of a stock or asset to reverse. The direction of the previous trend is likely to proceed once the asset price has retraced to one of the aforementioned ratios.
Fibonacci Retracements and Investors
Technical traders like using this tool because it helps them plot strategic spots on a chart for all kinds of different actions, including transactions, target prices, and stop losses. The concept of retracement that is at the heart of this particular tool is also applied in many indicators, and with good reason. After a substantial uptrend or downtrend, the new resistance and support levels are often plotted at or near these retracements.
The levels associated with Fibonacci retracements are static prices that don’t change, which makes them different compared to moving averages. This nature about the price levels allows investors to identify their location very efficiently, and it also makes it simpler for them to anticipate and react in a rational fashion when the price levels are tested. In other words, Fibonacci retracements can make a technical analyst act calmly in the face of fluctuation.
Fibonacci Retracement Levels and Trading
The price levels associated with Fibonacci retracement can be used as signals to buy on pullbacks when a stock is undergoing an uptrend. In this case, it is wise to have some momentum indicator like an MACD oscillator at the ready to hone in on the entries that are most advantageous. The levels can also be used during downtrends, specifically to short sell when stocks resist a Fibonacci retracement level. If a level price overlaps with different indictor price levels (such as a 200-day moving average, for example), then the level turns into a strong price level. This ends up making the support or resistance even stronger.
The most important Fibonacci ratio for investors is 61.8%, which is known as the “golden ratio.” This number can be translated to a retracement level of 0.618. For whatever reason, this particular retracement level tends to coincide with the maximum pullback zone, depending on how the market is swinging. On uptrends, this is the sequence where panic and nervousness rule the day, the sellers that dug in their heels finally abandon ship, and bargain hunters pounce to cause the uptrend. Conversely, on downtrends, the 0.618 price level is right around where the last of the buyers throw in the towel, short sellers dump their positions, and short-seller spring into action, thus causing the price to be pushed down.
There is a little bit of variance to this otherwise predictable pattern. Some investors will hang out for a couple of extra closures above or below a Fibonacci retracement level to make sure the support or resistant levels are accurate before executing a trade.
Confusing but Effective
Admittedly, the mechanics behind the Fibonacci sequence is an odd mystery, not only in the stock market but other aspects of the universe. It’s enough to blow one’s mind. It’s also sufficient to blow one’s investment strategy if not used with great care. Then again, this puts Fibonacci retracement in the same classification of any trading tool as it relates to the world of technical analysis. Savvy investors know that tools like Fibonacci retracements serve to minimize risk, but they don’t eliminate risk altogether. This is the first step investors must acknowledge on their way to profitability.
This technical indicator is used very often by many investors including Jason Bond.
With that being said, investors do not have to be mathematical geniuses to use Fibonacci retracing as a useful strategic tool. At the end of the day, the mechanics behind the numbers and how they correlate to specific critical levels doesn’t matter. The fact that they can be used to help investors pinpoint predictable investment sequences does.