Tuesday, February 22, 2011

What is a Fibonacci Retracement?

In a Fibonacci number sequence the first two numbers are 0 and 1, and each subsequent number is the sum of the previous two. Fibonacci numbers are frequently used in analysis of financial markets, but Fibonacci relationships appear in the biological world too.

In financial markets, Fibonacci retracements are used to identify areas of potential support (or resistance). Fibonacci retracements are built off the concept of the Golden Ratio. For financial markets this sets points of interest at Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.

The ratios for Apple (AAPL) are given below. How a stock behaves at each retracement can indicate the strength of a rally (or decline). In a strong rally (or decline) a retracement rarely gets below the 61.8% (or above the 38.2%) level. So AAPL could fall back to $315.42 and maintain strong bullish momentum. Looking at the chart, there is a congestion level between $300 and $320 which reinforces the potential for $315.42 to hold as support.

The next level down is 50% retracement. This falls at $300.24, the low end of the aforementioned congestion zone, but is a further reinforcement of the potential for buyers to come in around last October-December's trading.

Should the 61.8% and 50% retracement fail, then things get a little more sketchy for bulls. The next area for support lurks at $285.87 at the 38.2% Fibonacci retracement. Again, past price action is there to help with a reaction low around $280. A retracement which pushes all the way to 38.2% is one associated with a weakening rally. The large retracement creates large zones of overhead supply (which can be mapped using Fibonacci retracements too). Retracements down to the 38.2% level can evolve into lengthy sideways bases as bulls look to regain momentum but have to do all the hard work to bring the stock back to its highs.

Beyond 38.2% the picture swings towards a reversal. The 23.6% retracement is viewed as a last stand for the prior trend. For AAPL this is at $267.61. So whereas longs are using the higher retracements to look for buying opportunities, shorts are looking at the low end to grab a quick trade. Stocks which retrace beyond 23.6% typically retrace the entire move. So a loss of $267.61 sets in play a likely move back to $238.06 (and perhaps worse?).

So while we can't predict the future we can use Fibonacci retracements to identify where buyers (or sellers) may feel compelled to act.

Fibonacci Fans: A less used aspect of Fibonacci are Fibonacci Fans. Here the Golden Ratio is applied to different angled support lines - much like a trend line (as opposed to horizontal support).

Gann Fans: A variation of the Fibonacci Fan, except the ratio between each trendline is seperated by an eigth.

Fibonacci Time: This is an extension of the Retracement, but instead of price retracements it looks at time retracements. Both price and time Fibonacci sequences can be used together, guiding as to what price tests to look for and when to expect them. As with any technical indicator, they are best used as only a guide. If prices hit a retracement within a projected time frame it might point to a weakening of the prior trend. But if a retracement fails to occur within a suggested time frame it could suggest the opposite.

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