Fibonacci retracement

Prices rarely move in a straight line. After a strong rise, a stock or index usually gives back part of the gain before deciding whether to continue. Fibonacci retracement is a way of marking out in advance where such a pullback might pause, using a set of percentages taken from the Fibonacci number sequence. Traders use the levels to plan entries, place stop losses and judge whether a pullback is normal or something more serious.

Where the numbers come from

The Fibonacci sequence starts 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, and so on: each number is the sum of the two before it. Divide any number by the next one and the result settles near 0.618 (for example 55 ÷ 89). Divide by the number two places ahead and you get about 0.382, and three places ahead about 0.236. These ratios give the main retracement levels:

• 23.6%: a shallow pullback, common in strong trends.
• 38.2%: a moderate pullback.
• 50%: not a Fibonacci ratio at all, but included because traders watch halfway points.
• 61.8%: the "golden ratio", a deep pullback that many traders treat as the last line for the trend.
• 78.6%: a very deep pullback; beyond it, the move is usually considered over.

There is no proven law of nature that makes markets obey these ratios. They matter mainly because so many traders watch them, so orders cluster around them.

How to draw the levels

1. Find a clear swing. In an uptrend, a swing low followed by a swing high. Choose obvious turning points, not ones you have to hunt for.
2. Measure the move. Swing high minus swing low.
3. Subtract each percentage of the move from the high (in an uptrend). In a downtrend, draw from the swing high to the swing low and add the percentages to the low.

Level = swing high − (swing high − swing low) × ratio

A worked NIFTY example

Suppose NIFTY rallied from a swing low of 23,800 to a swing high of 25,800, a move of 2,000 points, and has started to pull back.

Notice that the 38.2% level, 25,036, sits right next to the round number 25,000, where option open interest often piles up too. A trader would pay more attention to that zone than to any single Fibonacci line, because several reasons for support meet there. If NIFTY falls through 24,564 (61.8%) and closes below it, many traders would conclude the rally from 23,800 has failed rather than paused.

Retracements in a downtrend

Fibonacci works the same way upside down. In a falling market, draw from the swing high to the swing low; the levels then mark where a bounce might stall. Suppose a stock fell from ₹1,600 to ₹1,300, a ₹300 drop. The bounce levels are:

A stock that bounces to around ₹1,450 and turns back down is behaving like a normal downtrend: lower highs after each fall. A stock that rises through ₹1,485 and holds above it has recovered most of the fall, and the downtrend is in doubt. Traders who are short often place their stops just above the 61.8% level for this reason, while traders looking to buy may wait for that level to be cleared before trusting the recovery.

Which swing to measure

Every chart contains swings within swings. On a daily chart of NIFTY there may be a six-month rally, a three-week leg inside it and a four-day move inside that, each with its own set of Fibonacci levels. Traders usually start with the most obvious swing on the timeframe they trade, then check whether a level from a bigger swing sits close by. When levels from two different swings fall within a few points of each other, that zone gets extra attention. When they are scattered, it is a sign the levels have little to say right now. Measure from clear turning points only: a swing low should have higher lows on both sides of it, and a swing high lower highs on both sides.

Combining Fibonacci with other levels

A Fibonacci level on its own is just a line. It becomes more interesting when it agrees with something else, which traders call confluence:

• A previous swing high or low (old resistance becoming support).
• A moving average, such as the 50-day or 200-day.
• A trend line or the lower edge of a channel.
• A pivot point level or a round number.

Here are today's readings for Reliance Industries, with its moving averages and pivot levels:

If you draw Fibonacci levels on its latest swing on the technicals page chart, check whether any of them land close to the 50-day or 200-day average or the pivot levels shown here. A 50% or 61.8% retracement that coincides with the 200-day average is a zone many different traders are watching for different reasons.

How traders use the levels

• Buying a pullback in an uptrend: wait for the price to reach the 38.2% to 61.8% zone, then look for a sign of buyers returning, such as a bullish candlestick pattern or a higher low on a shorter timeframe.
• Stop placement: just beyond the next Fibonacci level, or beyond the 78.6% level, since a deeper fall suggests the trend has changed.
• Targets with extensions: Fibonacci extensions project beyond the old high. The 127.2% and 161.8% extensions of the 23,800 to 25,800 swing, measured from the low, are 26,344 and 27,036. These are reference levels, not forecasts, and many traders take partial profits near them rather than treat them as exact targets.
• Judging the health of a trend: shallow pullbacks (23.6% to 38.2%) suggest strong buyers; pullbacks past 61.8% suggest weakness.

Limits and common mistakes

• Choosing the swing to fit the answer. Two traders picking different swing points get different levels. Use the most obvious swing on the timeframe you trade.
• Too many lines. With five retracement levels plus extensions, the price is always near some line. That makes Fibonacci easy to believe in after the fact.
• Buying blindly at 61.8%. A level is a place to watch for a reaction, not a reason to buy. Wait for the price to show it is holding.
• Ignoring the bigger trend. Retracements in a downtrend (bounces) are drawn the other way and are just as likely to fail.
• Forgetting gaps and news. A results-day gap jumps straight through levels, and no line on a chart can protect a position from that.