Fibonacci retracements are ratios used to identify potential price reversal levels. The ratios are found in the Fibonacci sequence with the most popular ones in trading being: 61.8% (typically rounded to 62%) and 38.2% (typically rounded to 38%).
These retracements can be combined with other measures like IV rank to identify possible trading opportunities.
Background On The Fibonacci Sequence
The Fibonacci sequence is a string of numbers in which each of the proceeding numbers is derived by adding the preceding two numbers. 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55 etc. (55 is obtained by adding 34 and 21, 34 is obtained by adding 21 and 13 and so on). This sequence goes on to infinity.
When you divide a number by the previous number, it approximately is equal to 1.618 (13/8 = 1.625, 8/5 = 1.6, etc.). As the number increase, the close you will get to being exactly 1.618. 1.618 is often referred to by trades as the golden ratio. This ratio can be found throughout nature, architecture, art, and biology.
The inverse of 1.618 is .618 which is approximately what you get if you divide any numbers in the sequence by the next highest number. (34/55 = .6181, 21/34 = .6176, etc.). This is the basis for the 61.8% fibonacci retracement used in trading.
Where does the 38.2% retracement come from then?
When you divide any number in the sequence by another number in the sequence that is two place higher, it equals approximately .3820 (13/34 = .382, 21/55 = .3818, etc.). Also, note that 1-.618 = .382.
What Do These Retracement Values Indicate?
Retracements that fall into the 38.2%-50% range are considered to be moderate (the 50% retracement is not based on Fibonacci’s sequence, instead, it stems from Dow Theory’s assertion that the averages often retrace half of their prior move.
A 61.8% is considered the golden retracement (it is after all, based on the golden ratio).
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