Retracement and Fibonacci Levels

Percentage-retracement levels are yet another technical indicator useful in defining short- and long-term price trends in a security or sector. Percentage retracement levels are based upon the collective belief that stocks and indices tend to "retrace" their paths after a sizeable move (in either direction). The simplest and most reliable retracement level is 50%. For example, if shares of XYZ rallied from a defined bottom of $25 to a high of $50, a pullback to the $37.50 region could be the stock's next move, retracing 50% (or $12.50) of its gain. All other things being equal, technical analysis would suggest that XYZ could rebound from this level, with the 50% retracement zone acting as a floor of support.

Retracement levels also work well over a long-term period. Solid uptrends or downtrends can persist for years. When they peter out, it can take the underlying instrument a fair amount of time to retrace 50% of its prior path.

Regardless of the timing of an equity's move to a retracement level, an important factor to remember is the closing level. A stock might hover close to a 50% retracement for weeks without ever managing a weekly or monthly close above it. There is a trade-off in technical analysis between jumping on a signal, thus possibly benefiting from a larger move, and waiting for confirmation. The latter strategy may sacrifice some potential gains, but it increases the odds of avoiding a fake-out.

The Fibonacci Element

Leonardo Fibonacci was a mathematician born around 1170 – what on earth did he know about the stock market? Assuredly nothing, but he did know his numbers. He discovered a relationship between a specific series of numbers that was so innovative it still bears his name.

The Fibonacci sequence is a series of numbers beginning with 1 in which each successive number is the sum of the two previous numbers: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 600 and so on. What is unique about the sequence is that any given number (after the first few small digits) is approximately equal to 1.618 times the preceding number and approximately 0.618 times the following number.

Within the field of technical analysis, the Fibonacci number sequence is applied to gauge price (and occasionally time) movements. The most commonly used numbers in this form of retracement analysis are 23.6%, 38.2%, 50% (as discussed above), 61.8%, and 76.4%. As prices retrace after a significant move in either direction, the underlying may stall at support/resistance near the Fibonacci lines. In a strong trend, the maximum retracement for an equity/index is usually 23.6% or 38.2%. In a weaker trend, one can generally expect the stock to retrace no more than 61.8% or 76.4% of its value.

The retracement-levels sequence is derived by dividing numbers in the original sequence by the numbers above them. For example, taking the Fibonacci number 89 and dividing it by itself equals 1 (100%), the beginning of the trend. Dividing it by a single digit above it (144) is 61.8%; by 2 digits above (233) is 38.2%, by 3 above (377) is 23.6%. One minus each of these levels gives the special Fibonacci retracement levels: 38.2%, 61.8%, and 76.4%.