When it comes to technical analysis, Fibonacci retracement is a very powerful tool used by traders on the stock market and currency markets. It was discovered by a 12 century monk know as Leonardo de Pisa who was known to his friends as Fibonacci. He discovered a mathematical sequence that appears throughout nature. To better understand how this sequence works or how it is applied to financial mathematics, we need to look at the Fibonacci numbers.
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, etc. You will see that each number in the sequence is the sum of the two preceding numbers. In other words 1+1=2 1+2=3 2+3=5 3+5=8 5+8=13 8+13=21 and so on. The important part of this is not the sequence, but the ratios that can be expressed between the sequenced numbers. This ratio, known as the Fibonacci ratio is achieved by dividing any number in the sequence with the number that follows it. For example 5 / 8 =0.625 13 / 21= 0.6190 55 / 89= 0.6180 The key Fibonacci ratio is .0168, also called the golden ratio.
There are 5 key ratios that are used 23.6%, 38.2%, 50%, 61.8% and 100%. Other ratios or multiples can be used if needed. Each Fibonacci level is an area where the market will likely see levels of support or resistance. It is important to find the low and high prices using a historical chart. The longer the history, the better the chance of the retracement lines showing significant support and resistance.
Place the Fibonacci lines over the extreme points of the dynamic trends using a fib grid. If you do it correctly, the results you see should clearly show that the majority of the market swings according to the Fibonacci ratios. This will allow you to identify where the next market swing should occur. You can then take a position in the stock either for the long term or short term. Once you get used to using this method it will be much easier and faster for you to use.
Caution should be used as the support and resistance may not occur at the levels you estimate. In some cases it may pass say the 38.2% level and instead reverse at 61.8% level. For this reason it is good to combine the results of the Fibonacci retracement with candlestick patterns to see if they both show resistance or support around the 38.2% area.