Understanding Fibonacci Retracement Levels and Their Significance

What is a Fibonacci sequence?

Italian mathematician, Leonardo Pisano, known to his friends as Fibonacci, introduced the concept of the Fibonacci sequence. Fibonacci first spoke about this theory in his book called “Liber Abaci (Book of Calculation)”.

Let’s understand exactly what the Fibonacci sequence is. 0, 1, 1, 2, 3, 5, 8,13, 21, 34, 55, 89, 144, 233, 377… and so on.

This is a Fibonacci sequence that can go up to infinity, but do you notice a pattern?

In the Fibonacci sequence, each number is the sum of the previous two numbers. For example,

1+2=3 2+3=5 3+5=8

Another interesting element of the Fibonacci sequence is that whenever you divide any number in the sequence by its succeeding number, the ratio will always be 0.618.

Let's test this out:

233/377 = 0.618 89/144 = 0.618

This ratio, when expressed as a percentage, comes to 61.8%. Similarly, if you divide a number by a number two places higher, you will see a consistent ratio of 0.382, i.e, 38.2%

34/89 = 0.382 21/55 = 0.382

You will observe this consistent pattern when you divide a number by a number 3 places above its place.

For example, 13/55 = 0.236 21/89 = 0.236, i.e, 23.6%

This is how the Fibonacci retracement levels that you see on the stock market are calculated.

Fibonacci retracement levels in the stock market

Like nature, the Fibonacci sequence appears in the stock markets as well. It is observed that whenever there is a sharp uptrend or downtrend in the stock price, the price tends to retract by a certain fraction before moving in a direction.

For example, if a stock price goes from ₹300 to ₹ 400, the stock price will retract to around ₹ 370 before it continues to rise.

This technique of identifying the stock retracement level is called “retracement level forecast”. It helps you identify entry, exit points and trading opportunities.

How to use Fibonacci retracement levels when trading?

When you open a stock chart, add the Fibonacci retracement tool by selecting the lowest price point and the highest peak. When you apply the Fibonacci retracement tool, horizontal lines will appear on the chart with levels from 0% to 100%.

Important points to remember:

• Take positions in the trade when the price is around 38.2% to 61.8%, which signifies a strong trade.
• Price correction of more than 61.8% is a weak trade.
• Price correction of less than 38.2% represents panic selling.

Fibonacci retracement can also be used when a stock is falling and you need to find out if and how much the stock will bounce back.

In a falling stock price, after the downtrend you may observe that the price would bounce back a little. When the price point is between 38.2% and 61.8%, that is usually the right time to enter a trade.

Do note that using Fibonacci retracement levels should not be used in isolation, other indicators should be used to successfully forecast price movements.