Fibonacci Retracement Guide: Sequence, Drawing, Pros & Cons

Fibonacci Retracement, also known as Fibonacci pullback, is a widely used technical analysis tool in financial markets such as stocks, futures, and FX. It is used to determine potential levels of support and resistance, which facilitates traders in making more informed trading decisions.

This article will introduce the basics of Fibonacci Retracement, including the origin and definition of the Fibonacci sequence, step-by-step drawing methods, a comprehensive analysis of advantages and disadvantages, and practical methods for analyzing support and resistance levels.

The Origin of the Fibonacci Sequence

The Fibonacci sequence is named after the Italian mathematician Fibonacci, i.e., Leonardo of Pisa. He lived in the 13th century and was one of the most famous mathematicians of medieval Europe. It was in the book published in 1202, Liber Abaci, that Fibonacci first introduced this sequence.

The discovery of the Fibonacci sequence originated from an interesting mathematical question involving rabbit reproduction under ideal conditions. The assumption is that a pair of rabbits reproduces a new pair every month, and the newborns also start to reproduce from their second month of life. If it starts from a pair of rabbits, how many pairs of rabbits will there be after several months? Fibonacci derived the renowned Fibonacci sequence while solving this question.

This sequence is not only widely applicable in mathematics but also observable in nature. For example, the arrangement of sunflower seeds, the spiral shape of shells, and the distribution of pinecone scales all demonstrate the patterns of the Fibonacci sequence. It has also been utilized in financial analysis, such as FX and stock markets.

Definition of the Fibonacci Sequence

The Fibonacci sequence is an infinite series starting with 0 and 1, with each subsequent number being the sum of the two preceding numbers. Its formula is as follows:

Some of the initial terms of the Fibonacci sequence are as follows:

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

This sequence has many interesting properties, one of which is its relation to the Golden Ratio. The Golden Ratio is approximately 1.618, and as the sequence progresses, the ratio of each term to its preceding term approaches this golden ratio.

The Golden Ratio

The Golden Ratio (𝜙, Phi) refers to the ratio of two numbers that equals the ratio of their sum to the larger number, i.e.:

In the Fibonacci sequence, the ratio between consecutive terms approaches the Golden Ratio as the sequence progresses.

This relationship is not only found in mathematics but also prevalent in nature, art, and architecture. The Fibonacci sequence and the Golden Ratio form the basis for many aesthetic and natural phenomena.

Formula and Common Levels of Fibonacci Retracement

Fibonacci Retracement lines are based on the ratios derived from the Fibonacci sequence, which facilitate traders in developing buy and sell strategies through the calculation of critical levels of price retracement. The formula and commonly used levels of Fibonacci Retracement are as follows.

Formula of Fibonacci Retracement

The levels of Fibonacci Retracement are calculated as percentages of the price movement from the start point (low) to the end point (high) of a trend.

Common retracement levels include 23.6%, 38.2%, 50%, 61.8%, and 78.6%.

These levels refer to the percentages of price retracement, i.e., the ratio of price retrace from a high level to a low level. Each retracement level has its important meaning.

The calculation formula and meaning of the retracement level are as follows:
Assuming the price has risen from lower level A to higher level B, then the Fibonacci Retracement levels can be calculated by the following formulas:

Where:

• A: Start Point of Trend (lowest level)

• B: End Point of Trend (highest level)

• C: The retracement level (%)

Retracement Level	Formula	Description
23.6%	C (23.6%) = B – (B – A) × 0.236	Weak pullback in an uptrend; minor rebound in a downtrend.
38.2%	C (38.2%) = B – (B – A) × 0.382	Common support level in an uptrend; common resistance level in a downtrend.
50%	C(50%) = B – (B – A) × 0.5	A psychological level, widely used in technical analysis, common in both uptrend and downtrend.
61.8%	C(61.8%) = B – (B – A) × 0.618	The level is based on the Golden Ratio, the support level in an uptrend, and the resistance level in a downtrend.
78.6%	C(78.6%) = B – (B – A) × 0.786	Deep retracement in an uptrend or strong rebound in a downtrend, indicating a possible trend reversal.

Advantages and Disadvantages of Fibonacci Retracement

As a technical analysis tool, while Fibonacci Retracement has wide application and significance, it also has limitations. The advantages and disadvantages of Fibonacci Retracement are as follows:

Advantages of Fibonacci Retracement

Advantages	Description
Easy to Use	The drawing and use of Fibonacci Retracement is relatively easy, only requiring identification of the start and end points of the trend.
Clear and Straightforward	Fibonacci Retracement clearly demonstrates potential levels of support and resistance, helping traders identify key levels of price changes quickly.
Wide Applicability	Fibonacci Retracement can be used across various markets, including stocks, FX, futures, and crypto, and is useful for both short-term and long-term investments.
Historically Validated	Fibonacci Retracement is based on historical price data, with many traders finding that these levels were effective in past markets.
Can Be Improved by Other Tools	Fibonacci Retracement can be combined with other technical tools, such as moving averages and RSI, enhancing the accuracy of trading strategies.

Disadvantages of Fibonacci Retracement

Disadvantages	Description
Subjectivity	The selection of start and end points for the trend is subjective, and different traders may choose different points, resulting in different retracement levels.
Over-reliance on History	Fibonacci Retracement is based on historical price data, but market movements are unpredictable, and past data may not accurately reflect future trends.
False Signals	Fibonacci Retracement levels do not always work, and market fluctuations may produce false signals, leading traders to make incorrect judgments.
Needs to Be Combined with Other Tools	The accuracy of Fibonacci Retracement is low when used alone, and it is best used in conjunction with other tools to improve the effectiveness of a trading strategy.
Impact of Market Sentiment	Fibonacci Retracement cannot account for market sentiment, and external events such as news or financial crises can cause markets to deviate from predicted levels.

Fibonacci Retracement Drawing Method (MT4/MT5)

Fibonacci Retracement is a simple and effective technical analysis tool that helps traders determine potential levels of support and resistance. Below are the detailed steps for drawing Fibonacci Retracement lines:

Step 1: Select the Start and End Points of the Trend

First, identify a clear price trend. This could be either an uptrend or a downtrend.

In an uptrend, select the start point (lowest point) and the end point (highest point).

In a downtrend, select the start point (highest point) and the end point (lowest point).

Step 2: Draw the Fibonacci Retracement Line

Find the Fibonacci Retracement tool in your charting software, which is typically available in most trading platforms.

After selecting the Fibonacci Retracement tool, follow these steps to draw the retracement:

In an uptrend:

Draw a line from the start point (lowest point) to the end point (highest point).

In a downtrend:

Draw a line from the start point (highest point) to the end point (lowest point).

The system will automatically calculate and plot the Fibonacci Retracement levels, which typically include 23.6%, 38.2%, 50%, 61.8%, and 78.6%.

MT4 Drawing Method:

Go to the menu bar and click on "Insert - Fibonacci - Retracement."

MT5 Drawing Method:

Go to the menu bar and click on "Insert - Objects - Fibonacci - Fibonacci Retracement."

Step 3: Identify Key Support and Resistance Levels

After drawing the Fibonacci Retracement lines, observe how the price behaves at the various retracement levels. Each retracement level could become a potential support or resistance level, applied as follows:

Support

In an uptrend, if the price retraces to a certain Fibonacci level (such as 38.2% or 61.8%) and holds, this level may act as a support.

Resistance

In a downtrend, if the price retraces to a certain Fibonacci level (such as 38.2% or 61.8%) and faces resistance, this level may act as a resistance.

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