Fibonacci retracement definition

What is a Fibonacci retracement?

A Fibonacci retracement is a key technical analysis tool that uses percentages and horizontal lines, drawn onto price charts, to identify possible areas of support and resistance. Identifying these areas is useful to traders since it can help them decide when to open and close a position, or when to apply stops and limits to their trades.

Why do traders use Fibonacci retracements?

Markets rarely move in a straight line, and often experience temporary dips – known as pullbacks or retracements. Fibonacci retracements are used by traders to identify the degree to which a market will move against its current trend.

The retracements are based on the mathematical principle of the golden ratio. The sequence for the golden ratio is 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, and so on, where each number is roughly 1.618 times greater than the preceding number.

To calculate Fibonacci retracement levels, technical analysts draw six lines on an asset’s price chart. The first three are drawn at the highest point (100%), the lowest point (0%) and the average (50%). The remaining three lines are drawn at 61.8%, 38.2% and 23.6%, which are significant percentages in the Fibonacci sequence.

According to the golden ratio, these lines should indicate the points where levels of support and resistance are met.

Pros and cons of Fibonacci retracements

Pros of Fibonacci retracements

As a means of identifying levels of support and resistance, Fibonacci retracements can be used to confirm suspicions of a market movement.

Levels of support and resistance can indicate potential upward or downward market trends and could therefore indicate to traders when is a good time to open or close a position. This means that Fibonacci retracements can be highly rewarding for traders who know when to use them properly.

Cons of Fibonacci retracements

However, Fibonacci retracements require a high level of understanding to be used effectively. Simply drawing lines on a price chart at the Fibonacci percentages will likely not yield positive results unless traders know what they are looking for. As such, beginner traders should take care when using Fibonacci retracements to be sure that a dip in an asset’s price is a temporary pullback, rather than a more permanent reversal.

Some traders feel that Fibonacci retracements are a self-fulfilling prophecy – because a lot of traders use Fibonacci retracements as a technical analysis tool, they are likely to get the same results. This means that orders tend to congregate around the same price levels, which could push the price in the desired direction.

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