Learn how to use Fibonacci retracements to predict changes in the price of a security over time by calculating key ratios based on the Fibonacci sequence.

How Do Fibonacci Retracements Work?

If you’re new to trading, the latest buzzword you most likely have come across is Fibonacci retracements. It’s a technique that a lot of traders use when analyzing trends in the financial markets. So what exactly are Fibonacci retracements and how do they work?

Fibonacci Retracements Explained

Fibonacci retracement is a mathematical method for determining how much the price of a security will change over time and in what direction. The process is stochastic since it’s impossible to predict where the price will go analytically. Typically, complex systems in the market influence the direction of the price.

To apply the Fibonacci retracement technique, you need to choose two extreme points within a particular period. These points represent the highest and lowest price of the security. You then calculate the vertical distance between these two points.

Key Fibonacci Ratios

The ratios used in the Fibonacci retracement technique are based on the famous mathematical sequence, the Fibonacci sequence. To determine these ratios, you take the golden ratio, which is equal to 1 plus the square root of 5 divided by 2, and raise it to different powers.

The key Fibonacci ratios are the golden ratio raised to the 0 power (100%), the negative 1 power (61.8%), the negative 2 power (38.2%), the negative 3 power (23.6%), and the negative infinity power (0%).

Horizontal Lines and Support Levels

Once you have determined the key ratios, you draw horizontal lines from 0% to 100%. The two vertical lines represent the highest and lowest price points, and the other three lines correspond to the intermediary ratios. This technique helps you determine support and resistance levels.

Support and resistance levels signify how far a price will increase or decrease to a certain level. Support and resistance levels can be used to determine the best points to buy or sell a security.

Conclusion

Fibonacci retracements are a useful tool for traders to analyze trends in financial markets. By determining the key ratios based on the golden ratio, traders can draw horizontal lines and make informed decisions about the support and resistance levels of the financial security. While Fibonacci retracements can be used, they are not a guarantee, and some discretion should be used when relying on them to make key investment decisions.