A Fibonacci retracement is a technical analysis tool that uses horizontal lines to indicate areas of support or resistance at key Fibonacci levels before an asset’s price continues in its original direction.
Understanding Fibonacci retracements
The Fibonacci retracement tool is based on the mathematical sequence identified by Leonardo Fibonacci. Traders use the tool to locate potential reversal points on a financial chart. The primary percentage levels used in this analysis are 23.6%, 38.2%, 61.8%, and 78.6%. An additional level of 50% is routinely included on trading platforms, though it is not a true Fibonacci ratio.
To apply the tool to a price chart, a trader identifies two extreme points. These points are normally a major peak and a major trough. The charting software divides the vertical distance between these two points by the key Fibonacci percentages. The resulting horizontal lines mark the price levels where a market pullback might pause or reverse.
This technical indicator is applied across international markets. Traders use it to analyze equities and forex pairs. The underlying assumption is that after a large price movement, the market will retrace a predictable portion of that move. Once the retracement hits a Fibonacci level, the price is expected to resume its primary trend.
Market participants generally do not use Fibonacci retracements in isolation. They combine these levels with other technical indicators like moving averages and volume data. This combination helps confirm whether a specific horizontal line will hold as support or resistance.
Example
Suppose our fellow Elephants are tracking the stock of Savannah Peanut Corp, an international agricultural supplier for elephant sanctuaries. The stock price climbs steadily from $10 to $20 during an uptrend. As Elephants look for an entry point to buy more shares during a market pullback, they apply the Fibonacci retracement tool from the $10 trough to the $20 peak.
A few days later, the stock price declines from $20 and settles at $16.18. This specific price aligns with the 38.2% Fibonacci retracement level. Selling pressure stops at this line, and new buyers enter the market. The $16.18 level holds as support. The stock then resumes its upward trajectory, validating the retracement level identified by the Elephants.