A very basic and easy to understand introduction to beginner Fibonacci Retracement Analysis.

Introduction to Retracements

Retracement is just another word for a pullback (as in a trend). Many traders look to enter market positions based on pullbacks. For example, let’s say that you want to go long NKE stock after it breaks out into a strong uptrend. How far would you let price retrace until you entered a long trade?

When you looked at the chart, what did you picture? Did you picture price pulling back (retracing) 1/3 of the way before entering a trade? How about 1/2 or 2/3 of the way? If you did then you are not alone. These numbers are pictured naturally by our minds in many applications and they appear in nature nearly everywhere we look.

Leonardo Fibonacci

Fibonacci was a leading mathematician in 12th century Italy. Among many of his great works, one theory was known as “Fibonacci Numbers” in which he assigned a series of numbers to things that that occurred repetitively in nature and in human architecture (it actually started with rabbit reproduction or some such I think). The numbers that we apply to trading, especially in price retracements (pullbacks), include 38.2% and 61.8%. We also use 50% though technically it was not in the series.

Support and Resistance From Fibonacci Retracements

Naturally, if buyers or sellers appear in greater numbers at these levels, a market’s price will react to them in some way. Not only does it come from our collective sub consciousness, but it becomes a self-fulfilling prophecy as we expect other traders to do something (buy or sell) at each level.

If we note these levels on a chart, we can reasonably expect price reactions of some sort at these levels. Modern charting software allows us to quickly place a grid on any chart and it does the math for us. The most common Fibonacci Retracement numbers (pullback percentages) used for trading are 0, 23.6, 38.2, 50, 61.8, 76.8 and 100. Here they are on the NKE chart. I zoomed in and elongated the chart so we can see it well. The top of the trend is the 0% line. Then we get each level down to what would be a 100% pullback of the trend.

Notice that after we saw a “top” in price that the stock pulled back for three days straight? Where did the buyers appear to stop the pullback? Yup – -  right at the 38.2% level (denoted by point A and the blue ellipse). Did price make it down to the 50% level or lower? I don’t know yet, lol. I will post the graph when it happens.

Long Term Fibonacci Retracement

Long term Fibonacci Analysis works great too. Check out this monthly chart of the Spiders S&P 500 ETF (SPY). It shows the downtrend of the Great Recession of 2008. Notice how accurately the counter-trend reacts to the Fib levels on the way back up. Looking at this chart, are we due to go back down to 123.37 at some point soon?

Using Fibonacci In Day and Swing Trading

Fibonacci Retracement Analysis is not an exact science. Sometimes price blows right past these numbers as if they do not exist. Other times these numbers work brilliantly like price ran into a brick wall. I tend to use these levels for targets more so than picking counter-trend reversal points – though they certainly have their use for that as well.

At least now you can “Understand Fibonacci” when you read about applying it in a strategy.