Introduction to the Golden Ratio and Fibonacci Retracements

This ratio is found in sunflowers, the Pantheon spiral galaxies and other natural and manmade structures. Nature, and humans which are a part of nature, seem to gravitate toward the Golden Ratio in such ways as how we assess beauty and buy and sell to determine market prices.

One of the ways isolate the Golden Ratio, or fractions of it, in financial markets is through two tools available on most charting platforms called the Fibonacci Retracement and Fibonacci Extension tools. These isolate areas of potential support and resistance providing potential entry and exit points for traders willing to learn how to use these tools.

Fibonacci Sequence and the Golden Ratio

Leonardo came up with the following series of numbers, within which there are some interesting mathematical properties:

0,1,1,2,3,5,8,13,21,34,55,89,144,233,377...

• Each number in the sequence is the sum of the two prior numbers (after 0 and 1)
• If you divide a number (after the first few in the sequence) by the prior number, the result is very close to 1.618.
• If you divide a number the next (higher) number, the result is very close to 0.6180.
• If you divide a number two spots higher, the result is very close to 0.3820.
• If you divide a number by three spots higher, the result is very close to 0.2360.

The Golden Ratio is 1.618, and the inverse of it is 0.618. Therefore, these levels along with 0.3820 and 0.2360 are used by traders to foretell areas of potential support and resistance as market movements seem to ascribe to similar relationships as in the sequence. The 0.50 level is also a common level used.

Usually these numbers are referred to as percentages in the follow way: a "61.8% retracement" or a "38.2% retracement."

Fibonacci Retracements

The mathematical properties above provide us with common retracement levels for market moves, namely 23.6%, 38.2%, 50%, and 61.8%. There are others, but these are the most common and generally the most useful.

A retracement is when the price of a trading product pulls back (retraces) a prior move. For example, if the price of a stock trends higher from $10 to $14, and then pulls back to $12, that would be a 50% retracement.

The stock moved up a total of $4 during the uptrend, but pulled back $2, or half of the prior gain.

Financial markets often retrace roughly 23%, 38%, 50% or 62% of a prior move (either up or down), and a simple tool available on most charting platforms lets you easily see these levels.

In the next down wave, the retracement following finds resistance at the 61.8 level.

While I have attempted to separate the Fibonacci Retracement drawings for easier reading, in practice it is fine to let them overlap. Having multiple drawings overlap each can actually be a valuable practise. When

Fibonacci levels from multiple drawings (even on different time frames) converge at a specific price, it is likely to be an important price and even a turning point.

Final Word

The Fibonacci Retracement is a simple tool that can be used to identify areas of potential support and resistance. Don't expect the market to stop exactly at a Fibonacci level. Often the price will come close to it, but not reverse exactly at it. The levels are a guide. Therefore, when trading off Fibonacci Retracements, don't make a trade anticipating a reversal at a certain level, but rather wait for the market to actually react off a Fibonacci level. For example, in a downtrend, if the price pulls back close to the 61.8 level and then begins to drop again, that is when you'd enter short (buy puts). Don't assume a Fibonacci level will hold, because there are multiple levels. Wait for the reaction off the level before taking action.

This article was contributed by Cory Mitchell CMT, who also writes for www.binaryoptions.net.