Fibonacci Retracement Method for Share Market

In this article, we are going to study about Fibonacci Retracement Method, which is used for technical analysis of stock chart. But before we do so, we need to understand the concept of price retracement.

Table of Contents

• What is Retracement?
• What is Fibonacci Retracement Method?

What is Retracement?

Traders always look out for opportunities to enter a trade at the right time. These opportunities present themselves at two instances:

• At breakout or breakdown of the price, i.e. when the trend of the chart reverses. Breakout indicates the start of an uptrend, and breakdown indicates the start of a downtrend.
• After retracement, i.e. after minor price reversals during an ongoing uptrend or downtrend.

During an uptrend or downtrend, the price does not move in a linear manner – it fluctuates. Even in an overall uptrend, there will be small time-zones wherein you will see the price coming down. Similarly, even in an overall downtrend, there will be small time-zones wherein you will see the price going up.

If we can identify how much the price will retrace the previous price movement, and then reverse again, we can find the right entry points for starting our trade.

What is Fibonacci Retracement Method?

Fibonacci Retracement is a method of technical analysis, which is ustilized to find out the support and resistance levels.

If the market is bullish, the price will go up. But generally, it will not keep going up. It will come down too after some time. This reversal of price movement is called retracement - temporary reversal of an overarching trend in a stock’s price. The concept is similar for a bearish market too.

Fibonacci ratios provide price levels to which markets tend to retrace a portion of a move, before a trend continues in the original direction.

This is an indicator that is available in almost all broker apps. When we plot this indicator on a chart, many Fibonacci Retracement Levels are displayed. These levels are horizontal lines that indicate where support and resistance are likely to occur. Each level is associated with a Fibonacci ratio or percentage.

So, before we move ahead, we need to understand the concepts of Fibonacci series and Fibonacci ratios.

What is Fibonacci series?

Italian mathematician Fibonacci introduced the concept of Fibonacci series, in which each number (from the third element onwards) is obtained by adding the previous two numbers in the series.

Fibonacci Series: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, …..

The numbers in this series are called Fibonacci numbers.

Fibonacci ratios or Golden ratios

If we divide a number of the Fibonacci Series with the subsequent number in the series, we get the same decimal number.

For example, 89/144 = 233/377 = 610/987 = 0.618 (though they are not exactly equal, but rather only approximately equal)

There naturally generated mathematical ratios are called Fibonacci ratios or Golden ratios. That’s because even nature seems to follow this, e.g. the number of petals in a flower are generally a Fibonacci number, etc.

When stock market experts decided to check whether this pattern is followed in stock market too, they were pleasantly surprised. Fibonacci ratios do seem to make their presence felt in stock market too. Some well-known Golden ratios / Fibonacci ratios have been given below:

• 0.236 or 23.6%
• 0.382 or 38.2%
• 0.500 or 50%
• 0.618 or 61.8%
• 0.786 or 78.6%

Using Fibonacci ratios in Stock Market

There’s a Fibonacci indicator on most broker apps, which you can plot over the graph of the stock/index.

For this you need to choose two points on the graph – a high and a low. For this you should wait till 11 AM and see the high and low points made by the chart till then. Before 11 AM the market is too turbulent and the data is not reliable.

When you plot the Fibonacci indicator over the graph, the golden ratios will be visible to you.

To make use of golden ratios, you must correctly identify the trend of the market. For this you may do technical analysis, or quantitative analysis (e.g. using PCR ratio).

• If PCR ratio > 1.25 (esp. if it’s over 2), then it means that the market is probably bullish, i.e. price is going up. But it will not go up in a linear manner – it will go up, retrace down, again go up, and so on. So, our aim here is to try to find the support from which the price may start moving up again after the retracement (this will be a good entry point). For this we plot the Fibonacci retracement indicator from low to high.
• If PCR ratio < 0.75 (esp. if it’s below 0.50), then it means that the market is probably bearish, i.e. price is going down. But it will not go down in a linear manner – it will go down, retrace up, again go down, and so on. So, our aim here is to try to find the resistance from which the price may start moving down again after the retracement (this will be a good entry point). For this we plot the Fibonacci retracement indicator from high to low.

Fibonacci ratios give us a good indication of the entry point (i.e. when to enter the trade). However, keep in mind that not all Fibonacci ratios are equally efficient – some are more efficient and safer than others.

• We should avoid entry below retracement of 50%. So, we should avoid 0.236 (or 23.6%) and 0.382 (or 38.2%) levels.
• The ideal entry points are above retracement of 50%. So, we should take entry between 0.500 (or 50%) and 0.618 (or 61.8%) levels.

If PCR > 1.25, i.e. the market is overall bullish, then we aim to find out how much the market may come down on retracement, i.e. we try to find the support.

After retracement, you should enter the trade once the next candle breaks the high of the retracement candle, and also engulfs the retracement candle. Right entry will improve your accuracy, i.e. chances of your making a profit.

You may keep the stop loss at the low of the retracement candle. So, it allows you to trade with a small stop loss. If you have a small stop loss, your risk-reward ratio will obviously be good.

If PCR < 0.75, i.e. the market is overall bearish, then we aim to find out how much the market may go up on retracement, i.e. we try to find the resistance.

After retracement, you should enter the trade once the next candle breaks the low of the retracement candle, and also engulfs the retracement candle. Right entry will improve your accuracy, i.e. chances of your making a profit.

You may keep the stop loss at the high of the retracement candle. So, it allows you to trade with a small stop loss. If you have a small stop loss, your risk-reward ratio will obviously be good.

Note

This method works the best with 30-minute candlestick chart. Using longer time-period candlesticks allows us to hold onto our position longer, which means that we can set higher profit targets.