The Fibonacci retracements – also called Fibonacci levels – are one of these indicators that fascinate new traders. First of all, the name sounds great and fancy. Second of all, the numbers seem to come out of nowhere. The mystery of these numbers (61.8, 50, 38.2, and so on) adds to the belief that people using the Fibonacci retracements are some sort of trading wizards. Lastly, but more importantly, they really seem to work very well in the markets.
All that mystery around the numbers, the fancy name and their cunning tendency of actually working on the charts have an unfortunate impact on some beginner traders: they don’t want to actually learn what the numbers are and how to use them.
In this article, we’re going to go over just that. We’ll figure out what the Fibonacci retracements are, why these numbers work and how they are used in the markets.
The numbers, what do they mean?
Let’s keep this short and sweet, because there has been thousands of books written about the Fibonacci sequence and to be honest we don’t need to go that deep. The Fibonacci retracements are based on a sequence of numbers (the Fibonacci sequence) invented – or rather found – by mathematician Leonardo Fibonacci. If you’ve seen or read the “Da Vinci Code”, you know what we’re talking about.
The sequence goes like this: 0, 1, 1, 2, 3, 5, 8, 13 and so on. Each number is the sum of the two numbers preceding it.
Great! Now how does that help? Well, the sequence itself doesn’t help much. The really interesting part is the relationship between each number expressed in ratio. Again, we won’t go in depth here but the ratio sequence goes like this: 23,6%, 38,2%, 50%, 61,8% and 100%.
It has been found that these ratios repeat and can be found in multiple areas of nature.
Alright, but what about the market?
Yes, that’s what we’re really in this for isn’t it? How do these numbers end up working out in the markets? Well, truth be told… We don’t really know! That’s right, a bunch of very intelligent people with very high salaries have been working on this for ages and we still don’t know why, but these numbers just work.
The way traders use them is by plotting what is called a “Retracement”. If you pull a straight line from top to bottom of a trend, and apply the Fibonacci sequence onto it by drawing levels at the specific numbers (23,6%, 38,2% and so on), you’ll often see that the market tends to slow down around these levels once the retracement is into place.
While we don’t really know why that’s happening (we do have a theory, but that will be in another article), it’s clear that it does work and traders should be aware of these levels whenever entering or managing a trade. Experienced traders tend, for example, to place partial closing targets around these levels to reduce their risk and lock in some profits.