Fibonacci Retracements

Fibonacci, pronounced fib-o-natchi, Retracements are a mathematical wonder. No one knows exactly why they work, nor indeed thankfully, do you need to know why they do work.

The Fibonacci retracement tool is one of several Fibonacci tools that are available to you, but the retracement tool is the only one of them that I use.

A retracement as you may recall, is where a stock has reached an overbought condition and retraces, takes back, some of its initial value. The retracement tool can be used to gauge a target for a chart that has reached an overbought position as previously mentioned, but can also be used to gauge how a potential bounce on the upside may fare.

The Fibonacci tool is based on a mathematical wonder discovered by Leonardo Fibonacci, way back when the world was flat and there was no Eastenders, which found that one number kept on popping up throughout the natural world, the ratio of 0.618…. ‘ooooh,’ I hear you coo in excitement. Well, in fact it seemed to apply to virtually anything from how petals formed to how our fingerprints grow. For us in the financial world, it relates to how consecutive numbers relate to one another.

Some of you will also see the familiarity between Fibonacci and Elliott Wave Theory and Gann Angles – you don’t have to see it of course, but those that do will understand that this theory seems to spring up everywhere and what’s more, it works. How or why it works, no one really knows, but it does.

There is a tool in some charting programs called the rule of eighths. If you don’t have a Fibonacci retracement tool, you can use this instead as they are very similar.

How we apply the Fibonacci tool is very easy. Once selected we go to the bottom of the current trend, which can be any point in the chart, but usually for the sake of a current near term retracement, the most recent smaller trend, and click and drag the tool up towards the top of the trend.

What will now be drawn is a trend line with three horizontal lines protruding out with values placed by them (not all charting applications have the values), but you can simply look along the lines drawn to see what prices each correspond to. The lines are draw at certain percentages, that are based on the Fibonacci mathematical rule.

The values are 38.2% – 50% – 61.8%.

These are the points where a stock is most likely to fall to in any given trend, that the Fibonacci tool is used to trace.

For example we can have a chart that shows a Long trend from 200 to 400, but we have a Doji candle with resistance at say 400, suggesting that a retrace (bounce on the downside) could be on the cards.

We take our Fibonacci tool and trace it along the main trend of 200 to the top at 400. Starting at 400 and dragging down to 200 where the trend started. We will see the tool draw the retracement lines at 323.60 (38.2%), 300 (50%) and 276.40 (61.8%).

From looking at these retracement lines you will more than likely see periods of consolidation that have happened in the past, at or near these same values. To gauge where a likely retracement will fall to, you are best at first looking for these prior periods of consolidation. As chances are the stock will fall to these same levels.

If no consolidation can be seen, which is unlikely, but possible. You can use the tool on its own. Most charts will fall on a retracement to at least the 38.2% line. Some depending on the extent of the overbought nature to 50% and rarely to 61.8%.

To use the retracement tool to find a target on the upside, from a chart that is reaching strong support is simple, as all you do is the reverse. You select your tool again and you drag your pointer from the bottom to the top of the previous short trend to the point of support. In our example from 200 to 400, so we get the percentages shown in reverse for our bounce on the upside. This will give you the reverse of the readings for an upward trend and point out potential levels where the stock will bounce to. In my experience, I have noted that a stock rarely bounces to 50% of the previous short trend, but more so heads to 38.2% before either moving back down or consolidating.

So there we have it. The mathematical tools that I use as a form of salt and pepper to bring out the flavour of the whole forming trend. They are easy to use.

I won’t bother showing you a picture of each, as I’ll soon illustrate them in action using videos media. You will see for yourself. Plus, on every chart I detail what I am looking for exactly, why I am looking at it and what this means. The above indicators will be included. Sometimes I may refer to them if I feel there is a need, other times I take little notice.

Why?

Well as with any combination of tools and this is part of the reason why I only take a small amount of notice of them, when even just a few tools are used, there is always a danger of placing too much credence on their ability to spot, or show forming trends. Now most of the time, such as when we’re using our MA lines, they show trends perfectly and supply us with perhaps all the information we need. However, it is always good to check, to clarify a situation. Much like asking for a second, even a third opinion. Sometimes these opinions prove to us that what we first thought is correct, sometimes they argue and contradict each other. It is when we have conflicting indicators that it can lead to confusion and possibly a missed opportunity.

So, when you decide to use indicators yourself don’t become too reliant on them. Trust your own judgement. Much like you would if you took a second opinion, it is only that – an opinion, what someone or something thinks may happen, but also may not happen.

A simple saying, ‘You can’t see the wood for the trees,’ I think sums up indicators perfectly when you read into them into too much detail, the message is clear – be careful when using indicators.

We’re almost done on techniques, tools, tips and tricks. The final ones I would like to cover are those that are used with high regard in Technical Analysis. Now what we are doing really is Technical Analysis. In fact it was Technical Analysis that got me interested in all this. It was many moons ago, that I realised that the psychology of a chart and reading that psychology actually had a name.

I will also cover my technique in scalping an overbought or oversold stock, known as a bounce and great for highly volatile stocks, such as those found in the NASDAQ and S&P100.

I can read bumps you know!

Well bumps, lumps, peaks and troughs in charts. I can almost hear all those people that thrive on Technical Analysis screaming at me. How could I make fun of such an established technique, quite easily actually. You see, even though I know Technical Analysis works to a degree, I would never, ever, rely totally on it. To me it hasn’t proved itself to be a diehard tool.

Having said that, I like to see if I can spot the following chart patterns in a chart. One, to see if they do what they claim, and two, to see if this improves my spotting of trends. So those of you that start to scream at me, when I start placing markers on charts suggesting Technical Analysis chart patterns – just humour me as that is what I am doing myself.

Now jokes aside. There are two important Technical Analysis tools that I do make a point of looking for, as they are simple and we like simple, they are effective and what’s more they work – most of the time.

Join the discussion

Share
Recommend this on Google

The content of this site is copyright 2014 Financial Spread Betting Ltd. Please contact us if you wish to reproduce any of it.