May 29, 2013 by tradersnote
There is a plethora of established tips, methods and strategies out there for traders to choose from. One popular method is known as Fibonacci retracement. This grand-sounding tool is named after Leonardo Fibonacci, a Thirteenth Century mathematician. Fibonacci identified a sequence of numbers. The relationship, or ratios, between these numbers forms the basis for Fibonacci retracement.
To use Fibonacci retracement first traders must identify the ‘peak’ point and the ‘trough’ point on a stock chart. You then use Fibonacci’s key ratios to divide the difference between the peak and the trough. These ratios are 23.6%, 32.8%, 50%, 61.8% and 100%. This division is marked on a stock chart with a line. Horizontal lines are then drawn to highlight possible support and resistance levels. For a clearer idea, here is a useful example of how that appears.
But why you would want to divide by those percentages anyway? First it is useful to establish the origin of these percentages. As stated, the Fibonacci retracement is based on a sequence of numbers, these are: 0,1,1,2,3,5,8,13,21,34 etc. Notice each new number is the result of the two previous ones added together. Oddly, each number is also roughly 1.618 times greater than the previous number, therefore if a number is divided by the one that follows it, it results in approximately 0.618. It is this similarity that paved the way for Fibonacci retracement. The 0.618 value results in the ratio of 61.8%. Similarly, the 38.2% ratio is created by dividing one number in the sequence by the number that came two places before it.
So how does all this maths become relevant to the stock market and make Fibonacci retracement such a popular tool for traders? For unexplainable reasons, these ratios work in a similar, patterned manner on the stock market as they do on Fibonacci’s sequence. Obviously assets do not always, consistently rise in value, but Fibonacci’s retracement method actually helps predict moments when an asset will reverse its trend. After this reversal, according to Fibonacci’s retracement, the asset’s value will continue its previous trend, prior to the fall in value.
So, by using the Fibonacci retracement, traders can predict that assets will tend to continue in a certain direction once a retracement has been completed. This means Fibonacci retracement is particularly beneficial to trading strategies that depend on price pullbacks.
This may appear as a somewhat strange and convoluted trading tool. However, it is worth investigating further and testing out, before you commit any funds, to trial its use for your goals. Take a stock chart for an asset and add the lines. With enough practice this ancient form of mathematics could help you achieve great successes on the stock market.