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Introduction to Technical Analysis

How to spot trend corrections using Fibonacci Retracement?

One of the common technical indicators used in currency trading to track future market trends is called Fibonacci Retracement. It is a principle based on an infinite number sequence discovered in the 13th century by the Italian mathematician, Leonardo Fibonacci. Basically you take two numbers like one and two, and then you add these two numbers together to get the third number in the sequence.

One of the remarkable characteristics of this numerical sequence is that each number is approximately 1.618 times greater than the preceding number. This common relationship between every number in the series is the foundation of the common ratios used in retracement studies.

In technical analysis, Fibonacci Retracement is created by taking two extreme points (usually a major peak and trough) on a chart and dividing the vertical distance by the key Fibonacci ratios of 23.6%, 38.2%, 50%, 61.8% and 100%. Once these levels are identified, horizontal lines are drawn and used to identify possible support and resistance levels. According to traders who follow this method, large price movements tend to pull back or reverse at one of the Fibonacci retracement levels.

The key Fibonacci ratio of 61.8% - also referred to as "the golden ratio" - is found by dividing one number in the series by the number that follows it. For example: 21/34 = 0.6176.

The 38.2% ratio is found by dividing one number in the series by the number that is found two places to the right. For example: 55/144 = 0.3819.

The 23.6% ratio is found by dividing one number in the series by the number that is three places to the right. For example: 13/55 = 0.2363.

Price tends to retrace 38.20% to 61.80% of the prior move before continuing in the same direction. For reasons that are unclear, these ratios seem to play an important role in the market, just as they do in nature, and can be used to determine critical points that cause an instrument's price to reverse.

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