Understanding the Basics of Fibonacci Retracements

The jury is out on the efficacy of the Fibonacci retracement tool

Digital Content Manager
Nov 12, 2020 at 2:47 PM

As new traders flood the market, a return to the basics may help novices understand the fundamentals of options trading. To better assist them, we will be running a weekly post about options education. This week, we will be diving into Fibonacci retracements, which are used to identify support and resistance levels, set target prices and place stop-loss orders, among other things.

But first, a little bit of context. Leonardo Fibonacci was a mathematician from the 1170s that discovered a relationship between numbers. Specifically, the Fibonacci sequence is a series of numbers in which each successive number is the sum of the two previous ones, as in: 1, 1, 2, 3, 5, 8, 13, and so on. What is fascinating about this sequence is that any given number is 1.618 times its predecessor, and 0.618 times the following number. Based on that, the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8%, and 100% were established.

When it comes to the stock market, traders use the above percentage ratios to draw Fibonacci retracements levels, which are useful in defining short- and long-term price trends, because they are based on the belief that stocks and indices tend to retrace their paths after making a large move in either direction. For instance, if a stock rallied from a defined bottom of \$25 to a high of \$50, a pullback to the \$37.50 region may be its next move, retracing 50% (or \$12.50) of its gain.

In other words, traders draw horizontal lines based on those key Fibonacci percentages to identify potential areas of support and resistance. Those percentage lines show how much a stock has retraced its prior move, and the direction in which it is likely to keep going.

There are pros and cons associated with using Fibonacci retracements. While some have confirmed its effectiveness, others believe it to be an unreliable tool, as it is not grounded in logic per se -- rather, it is a numerical pattern. This strategy is also only effective to indicate corrections and reversals, and doesn't provide clear signals as others strategies often do.

Nonetheless, many traders have been successful with the Fibonacci retracement tool. That is why, if anything, it is important to be aware of it when deciding on how to invest in an equity.

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