Fibonacci Retracement and the Golden Ratio

The man, the rule, and the math behind one of nature’s most recognizable number systems

In today’s article, we’re going to do a deep dive into one of the most reliable systems for creating technical indicators and how you can use Fibonacci retracement to your advantage. 

What is the Fibonacci Sequence?

Developed in the 13th century by the Italian mathematician bearing its name, the Fibonacci rule is a sequence of numbers, starting at zero, which is created by adding the previous two numbers together. The beginning of the sequence thus looks like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34…

When broken down into the commonly referred to “Golden Ratio”, it is believed that the sequence gives insight into where financial markets might be heading. When we look at the breakdown between the numbers in the sequence, a pattern emerges. Excluding the first few numbers, every number is about 1.618 times larger than the number before it, while being .618 times smaller than the number after it. 

This ratio has been used to describe just about everything, from the perfect composition of a photograph to the construction of the pyramids to the shape of a mollusk shell. 

A Mental Love Affair with Patterns

Our brains are hardwired to recognize patterns. Even sometimes when there is no pattern to be seen, our instinct and need to make sense of something might kick in and lead us to believe we’re seeing connections that don’t necessarily correlate.

While the Fibonacci sequence and the Golden Ratio are no mirages on the trading screen, it’s important to understand that these patterns won’t always work. But that’s not because we’re imagining things. 

The reason why Fibonacci retracement might not work all the time is that it’s fairly common knowledge. This means that you’re far from the only one who is seeing it and using the same indicators. Knowing this, smart traders will often play the opposite. 

Common Knowledge Can Be a Trap

In its simplest form, common knowledge is a risk and might lead you to trouble. 

As always, to avoid these traps, apply a rock-solid risk management plan, use tested confirmation techniques, and never forget your common sense. 

Calculating Retracement Levels with the Fibonacci Sequence

In order to use the numbers to find retracement levels, pick two points on a chart. These two points are usually a swing high and swing low point. Once the points are chosen, the Fibonacci lines are drawn as percentages of the move. 

Prices should retrace the difference by a ratio according to the Fibonacci sequence. This is usually 23.6%, 38.2%, 50%, 61.8%, or 76.4% retracement. 

When calculated correctly, these horizontal lines will show areas of support and resistance. 

Subjective Limitations

While Fibonacci numbers and levels can be a great tool to add as indicators, it’s important to remember that since they’re based on the highs and lows of each trader’s choice, the results will vary from trader to trader. 

Another problem with relying on these numbers too heavily is that they occur at so many levels and the market will bounce back and forth, ultimately making some look good after the fact. This doesn’t give an indication of whether the levels are appropriate for making real-time decisions or ones to be based on future moves. It is not easy to differentiate between the two.

This is why, if you’re going to use Fibonacci levels, to use them in accordance with other indicators. In order to confirm or dismiss levels, you need to compare them in order to know for sure what you’re looking at. When used in conjunction with other tools, Fibonacci levels are a great supplement to already solid and sound trading plans. 

Share: