In technical analysisFibonacci Retracements refer to the possibility that the price of a financial asset, such as currency pairs, back off a considerable percentage of the original movement and find levels of support or resistance at the levels established by the Fibonacci numbers before resuming the original trend. These levels are built by drawing a trend line between the end points of the movement in question, and applying the vertical distance the key percentages of 23%, 38.2%, 50%, 61.8%, 76.8% and 100% based on Fibonacci numbers.

Introduction

The second principle of technical analysis indicates that prices move in trends that can be bullish or bearish. Once a trend has sufficient termination signals, either by breaking its trend line, the confirmation of a trend change formation, or any other valid factor according to the theory of technical analysis, the analyst considers the possibility of a price reversal.

pullback represents, in simple terms, a movement in the opposite direction to the previous trend. It can take the form of a drop in price after an uptrend, or a rise in the price following a downward trend. Although the first movement could be called the pullback itself and the second movement a bounce or rebound, the term technically includes both reversal movements.

Magnitude of price retracements

With the confirmation of a reversal in the price, the trader will seek to calculate the likely magnitude of the movement. To achieve this, certain percentages obtained from the Fibonacci series are applied to the total magnitude of the previous trend. The percentages used are the following:
  • 61.8%: Also known as the golden mean or golden ratio is the limit of the quotient obtained by dividing an element of the Fibonacci series between the previous, as the series goes to infinity. 
  • 50.0%: it is the most commonly accepted retracement, equivalent to half the advance of the main trend 
  • 38.2%: Obtained by subtracting 61.8% of the unit (1000-0618 = 0.382) 
  • 100%: Equivalent to the full extent of the main trend.

Fibonacci retracements on an uptrend

To calculate the magnitude of the retracement, the following levels of the trend previous to the price reversal (corresponding to the movement extremes) are taken:
  • (A) Price Low (minimum price) during the previous trend 
  • (B) Price High (maximum price) during the previous trend
Subsequently, the numerical value of the difference (B) - (A) is obtained. To calculate the probable retracement levels, the following formulas apply:
  1. R1 = (B) - (0.382 X ((B) - (A))) Called the "first retracement or 38.2% retracement of (A) to (B)"
  2. R2 = (B) - (0.500 X ((B) - (A))) Called the "second retracement or 50% retracement of (A) to (B)"
  3. R3 = (B) - (0.618 X ((B) - (A))) Called the "third retracement or 61.8% retracement of (A) to (B)" 
  4. R4 = (B) - (1,000 X ((B) - (A))) Called the "total retracement or 100% retracement of (A) to (B)"
These levels are plotted on the price chart as horizontal lines, assuming they can act as support levels for retracement movements.

Fibonacci retracements on an downtrend

The calculation is equivalent to the above, taking into account that in this case the previous trend is bearish, and therefore the retracement is an upward movement in the price. To calculate the magnitude of the retracement, the following levels of the trend previous to the price reversal (corresponding to the movement extremes) are taken:
  • (A) Price High (maximum price) during the previous trend
  • (B) Price Low (minimum price) during the previous trend 
Subsequently, the numerical value of the difference (B) - (A) is calculated. This value represents the magnitude of the price change for the original trend. To calculate the likely retracement levels, the following formulas apply:
  • R1 = (B) + (0.382 X ((A) - (B))) Called the "first retracement or 38.2% retracement of (A) to (B)"
  • R2 = (B) + (0.500 X ((A) - (B))) Called the "second retracement or 50% retracement of (A) to (B)"
  • R3 = (B) + (0.618 X ((A) - (B))) Called the "third retracement or 61.8% retracement of (A) to (B)"
  • R4 = (B) + (1000 X ((A) - (B))) Called the "total retracement or 100% retracement of (A) to (B)"
These levels are plotted on the price chart as horizontal lines, assuming that may act as resistance levels for the bullish momentum.

Use of Fibonacci retracements

Metatrader 4 has multiple advanced technical analysis tools which are easy to use, including a feature that allows the trader to add Fibonacci retracement and extension levels at any price chart with any timeframe. Once the tool is activated, the trader should only determine the maximum and minimum points of a trend and drag the tool between these two points to automatically draw the major retracement levels, as shown in the following figure:



Later we will include an article with a tutorial on using Fibonacci tools in Metatrader.

Considerations

  • Retracement percentages must be calculated only after it has been confirmed the end of a trend. Fibonacci retracements are never calculated while the current trend continues.
  • Given that trends are always part of a longer term trend and in turn are made up of shorter term trends, the question about what trends should I use to calculate Fibonacci retracements does not have a simple answer.Overall, we should calculate the Fibonacci retracements on trends with clear signs of termination.
  • It is considered that a weak trend may have a retracement of 31.8%, while a very strong trend may have a retracement of 61.8%, before resuming its original direction. 
  • Some books mentioned a critical area of 33% to 38.2%, and 61.8% to 67%, rather than the specific levels. 
  • The most important criticism against the use of Fibonacci retracements are grounded in the theory of random walk, arguing that there is no justification for assuming that the price action has any reason to respect predetermined price levels.
 

In technical analysis, Fibonacci Retracements are price levels based on Fibonacci numbers which can act as support and resistence in clear bullish and bearish trends.

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