Leonardo Pisano, nicknamed Fibonacci, was an Italian mathematician born in Pisa in the year 1170. His father Guglielmo Bonaccio worked at a trading post in Bugia, now called Béjaïa, a Mediterranean port in northeastern Algeria. As a young man, Fibonacci studied mathematics in Bugia, and during his extensive travels, he learned about the advantages of the Hindu-Arabic numeral system.

The Golden Ratio

In 1202, after returning to Italy, Fibonacci documented what he had learned in the "Liber Abaci" ("Book of Abacus"). In the "Liber Abaci," Fibonacci described the numerical series that is now named after him. In the Fibonacci sequence of numbers, after 0 and 1, each number is the sum of the two prior numbers. Hence, the sequence is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610 and so on, extending to infinity. Each number is approximately 1.618 times greater than the preceding number.

This value:1.618 is called Phi or the "Golden Ratio". The Golden Ratio mysteriously appears frequently in the natural world, architecture, fine art, and biology. For example, the ratio has been observed in the Parthenon, in Leonardo da Vinci's painting the Mona Lisa, sunflowers, rose petals, mollusk shells, tree branches, human faces, ancient Greek vases, and even the spiral galaxies of outer space.

Fibonacci Levels Used in the Financial Markets

In the context of trading, the numbers used in Fibonacci retracements are not numbers in Fibonacci's sequence; instead, they are derived from mathematical relationships between numbers in the sequence. The basis of the "golden" Fibonacci ratio of 61.8% comes from dividing a number in the Fibonacci series by the number that follows it.

For example, 89/144 = 0.6180. The 38.2% ratio is derived from dividing a number in the Fibonacci series by the number two places to the right. For example: 89/233 = 0.3819. The 23.6% ratio is derived from dividing a number in the Fibonacci series by the number three places to the right. For example: 89/377 = 0.2360. 

Fibonacci retracement levels are depicted by taking high and low points on a chart and marking the key Fibonacci ratios of 23.6%, 38.2%, and 61.8% horizontally to produce a grid. These horizontal lines are used to identify possible price reversal points.

The 50% retracement level is normally included in the grid of Fibonacci levels that can be drawn using charting software. While the 50% retracement level is not based on a Fibonacci number, it is widely viewed as an important potential reversal level, notably recognized in Dow Theory and also in the work of W.D. Gann.

Fibonacci Retracement Levels as Trading Strategy

Fibonacci retracements are often used as part of a trend-trading strategy. In this scenario, traders observe a retracement taking place within a trend and try to make low-risk entries in the direction of the initial trend using Fibonacci levels. Traders using this strategy anticipate that a price has a high probability of bouncing from the Fibonacci levels back in the direction of the initial trend.

For example, on the EUR/USD daily chart below, we can see that a major downtrend began in May 2014 (point A). The price then bottomed in June (point B) and retraced upward to approximately the 38.2% Fibonacci retracement level of the down move (point C). 

In this case, the 38.2% level would have been an excellent place to enter a short position in order to capitalize on the continuation of the downtrend that started in May. There is no doubt that many traders were also watching the 50% retracement level and the 61.8% retracement level, but in this case, the market was not bullish enough to reach those points. Instead, EUR/USD turned lower, resuming the downtrend movement and taking out the prior low in a fairly fluid movement.

The likelihood of a reversal increases if there is a confluence of technical signals when the price reaches a Fibonacci level. Other popular technical indicators that are used in conjunction with Fibonacci levels include candlestick patterns, trendlines, volume, momentum oscillators, and moving averages. A greater number of confirming indicators in play equates to a more robust reversal signal.

Fibonacci retracements are used on a variety of financial instruments, including stocks, commodities, and foreign currency exchanges. They are also used on multiple timeframes. However, as with other technical indicators, the predictive value is proportional to the time frame used, with greater weight given to longer timeframes. For example, a 38.2% retracement on a weekly chart is a far more important technical level than a 38.2% retracement on a five-minute chart.

Using Fibonacci Extensions

While Fibonacci retracement levels can be used to forecast potential areas of support or resistance where traders can enter the market in hopes of catching the resumption of an initial trend, Fibonacci extensions can complement this strategy by giving traders Fibonacci-based profit targets. Fibonacci extensions consist of levels drawn beyond the standard 100% level and can be used by traders to project areas that make good potential exits for their trades in the direction of the trend. The major Fibonacci extension levels are 161.8%, 261.8% and 423.6%.

Let's take a look at an example here, using the same EUR/USD daily chart:

Looking at the Fibonacci extension level drawn on the EUR/USD chart above, we can see that a potential price target for a trader holding a short position from the 38% retracement described earlier lies below at the 161.8% level, at 1.3195.

The Bottom Line

Fibonacci retracement levels often indicate reversal points with uncanny accuracy. However, they are harder to trade than they look in retrospect. These levels are best used as a tool within a broader strategy. Ideally, this strategy is one that looks for the confluence of several indicators to identify potential reversal areas offering low-risk, high-potential-reward trade entries.

Fibonacci trading tools, however, tend to suffer from the same problems as other universal trading strategies, such as the Elliott Wave theory. That said, many traders find success using Fibonacci ratios and retracements to place transactions within long-term price trends.

Fibonacci retracement can become even more powerful when used in conjunction with other indicators or technical signals. Investopedia Academy's Technical Analysis course covers these indicators as well as how to transform patterns into actionable trading plans.