Fibonacci Retracement - Essential Ratios for Pullbacks and Extensions
Origins of the Fibonacci Sequence
The Fibonacci sequence was introduced by 13th-century Italian mathematician Leonardo Fibonacci. Each number in the sequence is the sum of the two preceding numbers.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, ...
Remarkable mathematical properties emerge from this sequence. Dividing any number by the next number converges to 0.618, and dividing by the number two places ahead converges to 0.382. Conversely, dividing any number by the preceding number converges to 1.618.
| Calculation | Result | Converges to |
|---|---|---|
| 89 / 144 | 0.6180... | 0.618 |
| 89 / 233 | 0.3819... | 0.382 |
| 144 / 89 | 1.6179... | 1.618 |
| 89 / 377 | 0.2360... | 0.236 |
1.618 is known as the Golden Ratio and is found throughout nature - from sunflower seed arrangements to spiral galaxy arms to the shape of hurricanes. The premise of Fibonacci analysis is that this universal natural ratio also applies to financial markets, which are shaped by collective human psychology.
Key Fibonacci Retracement Ratios
Fibonacci retracement is used to predict how much price will pull back after moving in one direction. The key retracement ratios are:
| Ratio | Meaning | Practical Role |
|---|---|---|
| 23.6% | Shallowest retracement | Minimal correction in strong trends |
| 38.2% | Shallow retracement | Healthy correction, strong trend intact |
| 50.0% | Middle retracement | Not directly from Fibonacci, but frequently works in practice |
| 61.8% | Deep retracement (Golden Ratio) | Most important ratio, last line of defense for trend |
| 78.6% | Very deep retracement | Near trend failure level |
While 50% is not strictly a Fibonacci ratio, Dow Theory also suggested that prices tend to retrace half of their previous move, making it important in practice.
Drawing Fibonacci Retracement on Charts
To draw Fibonacci retracement on a chart, you need two reference points.
Retracement in an Uptrend
- Start point: Recent major low (Swing Low)
- End point: Recent major high (Swing High)
- Draw the tool from low to high, and horizontal lines appear below the high at 23.6%, 38.2%, 50%, 61.8%, and 78.6% levels
- These horizontal lines act as potential support levels
Retracement in a Downtrend
- Start point: Recent major high (Swing High)
- End point: Recent major low (Swing Low)
- Draw the tool from high to low, and horizontal lines appear above the low at each ratio
- These horizontal lines act as potential resistance levels
Importance of Swing Point Selection
The accuracy of Fibonacci retracement heavily depends on which swing points you select. Choosing points from minor fluctuations yields meaningless levels; select clear, significant highs and lows for meaningful support/resistance.
Generally, follow these guidelines:
- Select clearly visible major highs and lows on your analysis timeframe
- The move should span at least several dozen candles
- Drawing Fibonacci on multiple timeframes and finding overlapping levels (Confluence) increases reliability
Interpreting Fibonacci Retracement
Judging Trend Strength by Retracement Depth
Where the retracement stops indicates trend strength.
| Retracement Stop Level | Trend Strength | Outlook |
|---|---|---|
| 23.6% - 38.2% | Very strong trend | Quick trend resumption likely |
| 38.2% - 50% | Strong trend | Healthy correction, trend resumption |
| 50% - 61.8% | Moderate trend | Trend resumption possible but cautious |
| 61.8% - 78.6% | Weak trend | Increased trend failure risk |
| Above 78.6% | Trend in danger | High reversal probability |
The 61.8% level (Golden Ratio) is particularly known as the "last line of defense for the trend." A bounce from this level suggests the trend is alive, but breaking below increases the probability of trend failure.
Trading Strategy at Fibonacci Levels
It's risky to trade directly at Fibonacci levels. You must wait for confirmation signals.
- Confirm candlestick reversal patterns at Fibonacci levels (hammer, engulfing, etc.)
- Check if RSI oversold levels coincide with Fibonacci support
- Confirm bounce begins with increasing volume
- Trade where moving averages and Fibonacci levels overlap
Fibonacci Extension
While Fibonacci retracement analyzes "how much will it pull back," Fibonacci extension predicts how far price will go after the trend resumes.
Key extension ratios are:
| Extension Ratio | Meaning |
|---|---|
| 100% | Additional move equal to previous move |
| 127.2% | Common first target |
| 161.8% | Golden ratio extension, most important target |
| 200% | Twice the size of previous move |
| 261.8% | Extended target in strong trends |
Fibonacci extension is even more effective when combined with chart pattern target calculations. When targets calculated by both methods align at similar levels, that price zone gains importance.
Combining Fibonacci with Other Tools
Fibonacci retracement accuracy increases significantly when combined with other technical analysis tools.
Fibonacci + Support/Resistance
Where historically important support or resistance levels coincide with Fibonacci levels creates very powerful price zones. For example, if a previous consolidation zone's top (resistance) aligns with the current 38.2% retracement level, a reaction at that price is highly likely.
Fibonacci + Moving Averages
Levels where the 50-day or 200-day moving average coincides with Fibonacci ratios are also noteworthy. Since moving averages themselves act as dynamic support/resistance, overlap with Fibonacci strengthens that price zone's importance.
Fibonacci + Divergence
When price reaches a Fibonacci support level while RSI or MACD divergence is confirmed, it becomes a very powerful reversal signal. Fibonacci tells you "where" the reversal may occur, while divergence tells you "why."
Why Fibonacci Works in Markets
Two perspectives exist on why Fibonacci ratios work in financial markets.
Self-Fulfilling Prophecy: Since countless traders watch Fibonacci levels, buy or sell orders actually concentrate when price reaches those levels. This perspective suggests trader behavior makes Fibonacci levels valid.
Universal Natural Ratio: The golden ratio exists throughout nature as a fundamental proportion, and since collective human psychology is part of nature, this ratio naturally appears in financial markets.
Regardless of perspective, it's hard to deny that Fibonacci levels work effectively in practice.
Common Mistakes and Cautions
Mistake 1: Poor Swing Point Selection
Drawing Fibonacci from minor fluctuations creates meaningless level proliferation. Select clearly distinguishable major highs and lows on your analysis timeframe.
Mistake 2: Trading on Fibonacci Levels Alone
Automatically buying or selling because price reached a Fibonacci level is risky. Always confirm with candlesticks, volume, and other indicator signals.
Mistake 3: Using All Ratios
Displaying 23.6%, 38.2%, 50%, 61.8%, and 78.6% all at once clutters the chart and creates the illusion that price will "hit Fibonacci somewhere." Focus on the three levels: 38.2%, 50%, and 61.8%.
Mistake 4: Ignoring Market Context
Fibonacci only makes sense in trending markets. Applying Fibonacci to directionless sideways markets creates confusion. Confirm trend presence with MACD or ADX before applying Fibonacci.
Summary
Fibonacci retracement predicts "how much will price correct," while Fibonacci extension predicts "how far will the trend extend." 38.2%, 50%, and 61.8% are the key ratios, and reliability is highest at levels that overlap with other technical tools. Whether a universal natural ratio or self-fulfilling prophecy, the practical value is significant given that countless traders watch these levels.
Next article: Divergence - When Indicators and Price Disagree