Fibonacci Retracement

Fibonacci Retracement is a popular tool used in technical analysis to identify potential support and resistance levels. The basic idea is that after a significant price move in one direction (either up or down), a stock's price will often pull back, or “retrace,” a predictable portion of that move before continuing in the original direction. These retracement levels are based on key ratios derived from the Fibonacci sequence. Traders draw horizontal lines on a chart at the key Fibonacci levels—23.6%, 38.2%, 50%, 61.8%, and sometimes 78.6%—to pinpoint where a pullback might stall and reverse. For example, if a stock soars from €10 to €20, a technical trader would watch the 38.2% retracement level at €16.18 (€20 - (€10 x 0.382)) as a potential area to buy on the dip, anticipating that the uptrend will resume from there. While widely used, it's a tool of market psychology and pattern recognition, not a reflection of a company's underlying business value.

The name comes from a 13th-century Italian mathematician, Leonardo of Pisa, also known as Fibonacci. He introduced a simple sequence of numbers to the Western world that has fascinated mathematicians for centuries: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, and so on. Each number is simply the sum of the two preceding numbers. The “magic” for traders comes from the ratios between these numbers. If you divide any number in the sequence by the one that follows it, the result will approach 0.618, also known as the golden ratio or Phi. For example, 21 / 34 = 0.6176. If you divide a number by the number two places to its right, you get a ratio approaching 0.382 (e.g., 21 / 55 = 0.3818). These ratios (61.8% and 38.2%) form the core of the retracement tool. The 50% level, while not an official Fibonacci ratio, is included because prices often retrace half of a prior move, a concept that predates Fibonacci analysis and aligns with Dow Theory.

Drawing these levels is straightforward once you identify a clear price trend. You are essentially measuring a recent, significant price move from its start to its end.

If a stock is in an uptrend, you are looking for a pullback or a temporary dip.

1. Find a recent, significant bottom, known as a swing low.
2. Find the subsequent top, a swing high.
3. Using a charting tool, you click on the swing low and drag your cursor to the swing high. The software will automatically draw the horizontal retracement levels (23.6%, 38.2%, 50%, etc.) between these two points. These levels now represent potential support, where the price might stop falling and bounce back up.

If a stock is in a downtrend, you are looking for a temporary rally or bounce.

1. Find a recent, significant top (a swing high).
2. Find the subsequent bottom (a swing low).
3. Click on the swing high and drag to the swing low. The levels drawn will now represent potential resistance, where the price might stop rising and resume its downward journey.

Now, for a healthy dose of skepticism. From a value investing perspective, Fibonacci Retracement is like consulting an astrologer for business advice. It has absolutely nothing to do with a company's intrinsic value, its earnings power, its debt levels, or its competitive advantages. It is purely a charting pattern. So why does it sometimes seem to work? One major reason is the self-fulfilling prophecy. With millions of traders worldwide placing buy or sell orders at these exact same levels, their collective action can create the very support and resistance they were trying to predict. They aren't discovering a natural law of the markets; they are the market. For a value investor, a price drop is only interesting if it pushes a stock's price significantly below its calculated intrinsic value. Whether that price happens to align with a 61.8% retracement level is a fun coincidence, not a valid investment thesis. Relying on chart patterns alone is a dangerous game of speculation, not investing. The fundamental question should always be: “Is this a wonderful business available at a fair price?” not “Did the price just bounce off a magic line on a chart?”

While you should never base an investment decision on Fibonacci levels, understanding them can provide context for market movements.

• Tool, Not a Thesis: Fibonacci Retracement is a technical tool for spotting potential entry and exit points based on price patterns. It is not a fundamental analysis tool.
• Not Infallible: These levels are often broken. They are areas of potential price action, not certainties.
• Psychology, Not Physics: Its power stems from the number of people who use it, not from any mystical property of numbers.
• Value First: A value investor should only consider buying a stock when it's undervalued. If a Fibonacci level happens to highlight that opportunity, great. But the reason to buy is the value, not the level. It can be, at best, a secondary tool to help time a purchase in a great company you've already researched thoroughly.