Fibonacci Retracements

Leonardo Fibonacci was a 13th century mathematician who noted that the natural world seemed to consistently repeat the same set of numbers. Everything from the number of seeds in a sunflower to the petals on various flowers seemed to adhere to this rule and from this, Fibonacci developed the Fibonacci Sequence.

Technical analysts have adapted the Fibonacci Sequence for the purpose of predicting new rate levels immediately after a major rate fluctuation. The theory is that after a rate spike in either direction, the rate will immediately return – or retrace – back to a more appropriate level and then continue in the original direction. The retracement may not be to exactly the level before the spike, but the retracement level often aligns with a number from the Fibonacci Sequence.

Charting packages that offer Fibonacci Retracement generally provide the first few numbers in the sequence and overlay these levels as a percentage of change onto a price chart. Most systems also include 50% and 100% intervals as well.

To see how Fibonacci Retracement lines are used, let’s consider an exchange rate that is tending upwards – after a particularly large increase, the price often retraces (pulls back) part of the gain before continuing upwards. These retracements are the levels that traders watch for when determining new support and resistance levels in order to determine a trading strategy.

The same principle applies for a price that is trending downwards. Again, you should expect some retracement after a large price drop as support levels are reached that push the price back part way, but perhaps not all the way back, to the previous level. Some analysts feel that Fibonacci lines can serve as a guideline for predicting new support levels in a falling market.

The Fibonacci Sequence

Fibonacci’s sequence consists of adding one number with the previous number to arrive at the next number in the sequence. For example:

0 + 0 = 0

0 + 1 = 1

1 + 0 = 1

1 + 1 = 2

2 + 1 = 3

3 + 2 = 5

5 + 3 = 8

and so on. Following this pattern, the first 25 numbers in the Fibonacci Sequence are 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181, 6765, 10,951, 17,716, 28,667, 46,383

Sample chart – courtesy OANDA Corporation

In the illustration above, we have a Minimum / Maximum price chart with the standard Fibonacci Retracement lines added. You can see that the price fluctuations have – for the most part – matched the lines and by projecting them forward as we have here, we now have resistance and support level projections to help identify possible price reversals.

Experience has shown that the markets tend to follow the Fibonacci Retracement levels and each one displayed here should be considered as potential reversal points. Because Fibonacci Retracements are one of the most commonly-used technical charts, traders tend to act on the retracement levels which helps reinforce them as good price reversal indicators.

It is only prudent of course that you do not act solely on Fibonacci levels to make decisions. You should also seek out other evidence that a support or resistance level has indeed been reached – perhaps through a candlestick chart or other form of bar chart. Also, keep in mind that of all the charting methods used by traders, Fibonacci Retracements may well be the most effected by the concept of the self-fulfilling prophecy inherent in technical analysis. Essentially, this means that if many traders are watching for a sell signal to happen at a point as determined by a Fibonacci line chart, the very act of all these traders selling could drive the price down for no other reason than many traders are dumping the currency pair.

Related Links

An Introduction to Technical Analysis

Ask Price, Average Price, and Bid Price Line Charts

Fibonacci Retracements

Advance / Decline Line

Oscillators

Technical Analysis vs. Fundamental Analysis