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The fibonacci retracement itself is based on ratios derived from the Fibonacci sequence. This is itself based on a series of numbers identified by the Italian mathematician Leonardo of Pisa (known as Fibonacci) in the 12th/13th century. Each number in the sequence is the sum of the two prior numbers.
|0+1 = 1||1+1 = 2||1+2 = 3||2+3 = 5|
And so on… The relationships between the numbers in the sequence give some significant ratios which have been found to occur naturally in the world. If one divides 55 by 89 (two consecutive numbers in the above sequence) we get 0.618. In fact, this number is obtained whenever the smaller of two consecutive numbers is divided by the larger. The “Golden Ratio” comes from dividing the larger number in a consecutive pair by the smaller, so giving the reciprocal or 1.618. But while the history and maths is interesting, the details are well beyond the scope of this short blog. Instead, the following should be used as a basic introduction to the drawing tool itself. The starting point for using the Fibonacci Retracement is to identify a significant high/low (or low followed by a high) on a chart. Here’s an example using a daily chart of gold where I’ve identified a significant high from summer 2016 followed by the low which followed in December that year.
We then apply the Fibonacci Retracement to these two points, clicking on the high point first and then dragging across to the December low. Don’t worry if you can’t do this with pin-point accuracy to start with. It’s very easy to click back on each point and fine-tune the placement of the high-low points later on. This is what it should now look like:
As we can see, the high/low points are connected by a downward-sloping diagonal line. Then we have a number of horizontals which divide up the move into defined segments. These are the key Fibonacci retracements which are calculated by using numbers within the Fibonacci sequence. These key levels are either displayed as a percentage or decimals. The starting point, which is the high in this instance, is 100% (or 1) while the low is 0% (or zero). The Fibonacci Retracement can also be drawn between a low followed by a high as shown below. Here the low (starting point) is 1 or 100% while the high is zero (0%).
But it is the horizontal lines which are most important. These horizontals represent a certain percentage retracement of the original market move. That’s why the start point is 100% and the end point zero. As we can see in the chart above, after rallying sharply prices come close to retracing 100% of the upside move before recovering. There are a number of important Fibonacci retracement numbers, but the key ones for most traders are 23.6% (0.24), 38.2% (0.38), 61.8% (0.62) and 78.6%. Some charting packages, such as Spread Co’s, use 76.4% (0.76). This isn’t strictly speaking a Fibonacci number but it does mirror the 23.6% horizontal. The 50% line also isn’t a Fibonacci Retracement level. Nevertheless, it appears in the drawing tool and can often acts as an area of support/resistance where a price reversal can occur. The 50% level is also a key number in the Gann retracement (a similar drawing tool) so this is another reason for keeping an eye on it. There are also Fibonacci Extensions which are extremely popular with traders, particularly the 161.8%. An extension is used when the price retraces more than 100% of the original move. So, let’s look at the gold chart in more detail:
Here we can see how gold bounced sharply after hitting a low in December. It took a few goes to break above the 0.24 retracement level which could have provided a brief selling opportunity for day traders. However, the pull-back was short-lived and it wasn’t long before gold powered through here and was soon trading around $1,220 – marked by the 0.38 Fibonacci Retracement line. This was a much better shorting opportunity as gold tested and retested this level before pulling back sharply all the way down to the 0.24 level once again. This provided a perfect opportunity to close out the short and then turn bullish in what does, after all, appear to be a healthy uptrend following last year’s sell-off.
This was confirmed as gold hardly paused as it once again tested resistance around the 0.38 Fibonacci Retracement level. In fact, the next chart shows how this Fib retracement level, corresponding to a gold price of $1,220, is now acting as support. Not only that, but recent upside momentum proved strong enough to drive gold up through $1,250.
It’s interesting to see how this $1,250 level, which is the 50% retracement of the July-December 2016 sell-off, acted as significant support in October. If this past pattern repeats then $1,250 may prove to be the foundation for another leg higher in the rally.
Much depends on what happens over the next few sessions. And this in turn will depend on how the dollar behaves, which is often a key factor when it comes to movements in precious metals, and other dollar-denominated commodities. There can be little doubts that gold was oversold back in December while the dollar was overbought. But the question is whether gold’s upside momentum can continue or not, and much could depend on investor risk appetite. The Fibonacci Retracement can provide a framework to help identify significant areas of support and resistance. However, this isn’t a strong enough basis on its own for a full trading decision. The Fibonacci Retracement should be used as a predictive tool. Traders can look back to see how prices behaved as the high-low (or low-high) Fibonacci points were formed. But ultimately the Fib is only useful if it can accurately identify significant support/resistance levels where prices may either turn, or, once broken, continue in the original direction. However, it needs to be used in conjunction with other technical indicators (such as RSI or MACD) while macro events must also be taken into consideration.
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