Fibonacci Retracement

Leonardo Fibonacci, a famous mathematician, identified a sequence of naturally occurring numbers. The Fibonacci sequence of numbers are as follows: 0,1,1,2,3,5,8,13,21,34,55 etc. Each term in this sequence is simply the sum of the two preceding terms, and on it goes until the sequence reaches infinity. One of the remarkable characteristics of this numerical sequence is that each number is approximately 1.618 times greater than the preceding number. This common relationship between every number in the series is the foundation of the common ratios used in retracement studies.

In Practice

The Fibonacci trading concept is readily understandable: the theory just gets a bit bogged down. It is worth persevering with the concept as it is widely used and can be clearly seen again and again on any stock or index charts. Under the Fibonacci trading system, a trend is not technically broken unless the share price has moved by more than 61.8%. So if in an uptrend the share price falls (retraces) by more than 61.8%, then in theory the uptrend is reversed. If the share price only retraces by 38.2% or 50%, the pull back is temporary and the trend will continue. Logically, the less the stock retraces the stronger the trend so a 38.2% retracement is not as significant as 50%. The same applies in downtrends.

Example

The following chart is of the XJO (Top 200 stocks) since the April highs of this year to the present. Sometimes this technical analysis technique can work rather well, for instance, in the example below you can notice how many times the share price either bounced, held of went through the Fibonacci levels.

In the above chart the yellow rectangular area is the 38.2% to 50.0% retracement level and the aqua rectangle is the 50.0% to 61.8% area. Notice how many times these levels become either resistance or support, before the XJO breaks above the 61.8% retracement level and keeps going.

NB: The 23.6% level isn't as significant as the other three levels.