But the origins of one of the most useful retracement theories for stocks and other markets came from someone who lived in the Middle Ages and was studying the population growth of rabbits. Leonardo Fibonacci was an Italian mathematician who was doing this aforementioned work in the early 1200s. The number sequence that is named after Fibonacci is where each successive number is the sum of the two previous numbers, that is: 1, 2, 3, 5, 8, 13, 21, 34, 55, 144, and so on. Any given number is 1.618 times the preceding number (approximately) and .618 times the following number. There are some technical indicators whose formulas rely on the Fibonacci number sequence, but a big application is to use the Fibonacci retracements of .382 or 38 percent, .50 or 50 percent and .618 or 62 percent. The number 5 is in the Fibonacci sequence, and the others are ratios—.618 comes from the percent that each number is of the next higher number and .382 is the inverse of .618 (100 – 61.8 = 38.2). We’ll stick to the shorthand and round off to 38 and 62 percent. Also, as I used to say in my CNBC.com columns, a “little bit” more or less than 50 percent—the little bit, being approximately an eighth of a point either way—someday I’ll have to explain that they used to trade stocks in eighths of a point (dollar) increments but decimal trading is still fairly recent.
What you most need to know is that tracking what would constitute the 38, 50, and 62 percent retracement points, after a minor or intermediate price swing, is a common practice and a quite popular point of reference, especially among professional traders. There is a simple pragmatic reason for this popularity—buying or selling in these retracement areas often results in coming close to buying at the low and selling at the top. Maybe the saying “Buy low, sell high” owes something to the common retracements.
You can set most charting applications to calculate popular retracements ranging from .33 to .38, .50, .62 and .66 by pointing first at the low, then the high (pullback retracements) or first at the high, then the low (for retracement rallies in a downtrend). Or you can use a calculator and calculate the three percentage figures once it appears clearly that a high and a low are in place for the minor or secondary trend in question, and from which you can now calculate retracement possibilities. In an uptrend, once a minor downside correction begins, subtract the point figures that would represent a 38, 50, and 62 percent retracement (of the recent high minus the low) from the recent high. All you need is some degree of assurance or assumption that a price swing has run its course and that a countertrend move is developing. In a downtrend, the 38, 50, and 62 percentage figures are added to the most recent low. In a downtrend, once it’s apparent that a minor countertrend rally is underway (prices and volume surge), the expectation is that in a normal market prices will rebound an amount that is equal to about half of the last decline—or “a little bit more” (62 percent) or “a bit less” (38 percent). Then, for example, if prices climbed to the 62 percent retracement level, in a downtrend, this would suggest a favorable exit if long, and trade entry to sell short.
Here are some guidelines relating to the use of Fibonacci retracements.
- A strong trend will usually see only a minimum price retracement around one-third to 38 percent. If prices start to hold around this area, trade entry may be warranted.
- A normal trend, not powered by something extraordinary, will often see a retracement develop of about half or 50 percent of the prior move. A common area to buy or sell is at the 50 percent retracement level, with an exit if prices continue much beyond 62 percent, for example, 5 percent more.
- Within the range of normal, but not evidence of a particularly strong trend, will be a retracement of 62 percent or perhaps two-thirds (66 percent). If prices hold this area, it’s also a good target for initiating a buy or sell with an exit if the retracement exceeds 66 percent.
- If a retracement exceeds one level, look for it to go to the next, for example, if a retracement goes beyond 38 percent, look for it to go on and approach 50 percent. If it exceeds 50 percent, look for 62 percent. If a retracement exceeds 62 percent, or a maximum of 66 percent, then I look for what I call a “round trip” or a return all the way back to the area of the prior low or high—this type of action suggests a retest of the low or high and is the ultimate retracement, of 100 percent.
- Retracements are most commonly done from the low to high, high to low and not based on the highest close to the lowest close, and so on. However, you can experiment with retracements based on closing levels as they also are worth exploring.
- The common retracement levels work on all time frames, for example, hourly (or less), daily, weekly, and monthly charts.
Read More : What You Should Know About Retracements
