Fibonacci Retracements
Fibonacci Retracements
Looking at a stock chart, it’s easy to see that no stock moves in a straight line. Even a strong trending stock will have periods of expansion and contraction. Periods of expansion are manifest as movements in the direction of the trend, either up or down. Contractions, often called “consolidation” or “retracements”, are periods where the stock fails to trend or expand. Often, the consolidation or retracement is a move that is opposite or ‘counter’ to the larger trend.
The daily chart below of Mosaic Co. (MOS) shows these periods of contraction and expansion. I’ve circled the areas of contraction (consolidations and retracements), while leaving the periods of expansion alone as they are plain to see.
It’s obvious that the most money is made while the stock is in a period of expansion. However, these periods often don’t last that long and are fast moving.
These periods of expansion and contraction can be also seen on a downward trending stock as we can see in this daily chart of Starbucks Corp. (SBUX).
Again, I’ve circled the areas of contraction/consolidation, leaving periods of expansion clearly visible.
Stocks might trend, but they don’t move in straight lines. However, our success will always be increased by going with the trend instead of going against the trend. Once we’ve identified the direction of the trend, we can look for a possible entry. Many traders prefer to enter on pullbacks or retracements. The problem with a retracement is that it’s hard to tell where it will end. We don’t want to enter on a retracement, only to find out that the stock has further to go before the retracement is finished.
One method that some traders use to find potential entry points during a retracement is by using Fibonacci ratios.
Fibo what?
Fibonacci isn’t a what, it’s a who. Leonardo Fibonacci to be exact. Okay, his real name was Leonardo Pisa (since he came from Pisa, Italy) but somehow his name changed to Fibonacci which a good thing because you sound so much more impressive by saying “It’s a Fibonacci number” than you would by saying “It’s a Pisa number”.
Anyways, Leonardo Fibonacci was born around 1175. He was the son of a customs officer and was actually educated by the Moors in North Africa. He became famous for his mathematical skills. One of his most famous contributions to mathematics came in the form of the Fibonacci number sequence.
Fibonacci proposed the following question: if you were to put two rabbits into a field that had high walls on all four sides, so no rabbit could exit and no new rabbits could enter, then how many rabbits would you have after a certain amount of time? To answer this question, Fibonacci introduced his number sequence which begins with 0. The next number is 1. If you take 1 and add it to 1 you get two. After this step, you add the last number to the prior number, so 2 + 1 and you get 3. Then add 3 to the prior number, that being 2 and you get 5. Add 5 to 3 and you 8. Soon you get the following sequence,
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610…
To get the next number in the sequence, you just add 377 to 610 and you get 987.
So, now that we have the Fibonacci number sequence, we can get the Fibonacci ratio. This is done by just dividing one Fibonacci number by the number right before it. So 8/5 (8 divided by 5) = 1.6.
If you take any number greater than 3 in the sequence, and divide it by the prior number, you get 1.6 for the first few numbers, but eventually you’ll start to get 1.618, so 233/144 = 1.618. So 1.618 is a very important ratio number.
Once you have the 1.618, you take its reciprocal, .618 and turn it into a percentage: 61.8%. An easier way to get this number is just reverse the order of the two numbers you are dividing, so take 144 and divide by 233 and you get .618 (don’t worry, this is for background knowledge, you don’t need to know all this).
Now from here the math gets more tedious, a clear sign that someone had a little too much time on his hands. So instead of boring you with math and explanations, let me just say that the following numbers are your Fibonacci ratios expressed as percentages:
23.6%, 38.2%, 50%, 61.8%, 78.6%
However, the numbers you should pay the most attention to are 38.2%, 50% and 61.8%.
These ratios show up all around in nature, in flower petals and pine cones. There are books written about this but you could also do an Internet search if you want to learn more. The actual mathematics is not that important, so don’t worry if it makes no sense to you. All you need to know is how to use these numbers.
So what does this mean?
Many traders apply these Fibonacci (Fib) numbers to trading in many ways. For example, a trader might use moving averages that are Fibonacci numbers rather than non-Fib numbers. This is why although many traders use the 20-day Exponential Moving Average (EMA), many other traders use the 21-day EMA because it’s a Fib number. This solves the mystery as to why we use the 21-day EMA as the default moving average in Stock Investor.
The most popular use of Fibonacci numbers and ratios is to measure the expansion and contraction moves of the market that we talked about earlier in the article. After an expansion period, a stock will often contract or ‘retrace’ by 38.2%, 50% or 61.8% (stocks in very strong trends might only retrace 23.6%). Let’s say a stock moves from $50 a share to $70 a share. By this time, the stock is due for a pullback as nothing moves in a straight line forever. Many traders will look for the stock to come to a Fib level and begin buying at these levels.
In the example above, the stock moved from $50 a share to $70 a share or an increase of $20. By calculating the Fibonacci retracement levels we get the following price levels where we’d would start looking for an entrance:
38.2% = $62.36
50% = $60.00
61.8% = $57.64
A trader would look for the stock to find support at or around one of these price levels, and when it does, they would enter a buy order.
This sounds like a lot of work, fortunately, Stock Investor comes with a drawing tool that calculates these levels for you and marks these levels on a chart. To access this “Fibonacci Retracement” drawing tool, simple click on the drawing tool icon above any chart. Your drawing tools will most likely appear in the lower left corner of your screen (if you don’t have your page monitor on, they will come in the form of a pop-up window.
You can see the drawing tool icon; it’s a picture of a hammer and wrench (Arrow A). The Fibonacci Retracement Drawing Tool is a series of horizontal lines (see arrow B). To use the tool, click on the Fibonacci Retracement icon, then put you cursor at the point you wish to begin drawing your Fib levels, click once, then move your cursor over to where you want it to end. To measure retracements that are part of an uptrend, you start at a significant low, and end at the most recent high.
One the daily chart of Celgene Corp.(CELG) below, I’ve pointed to the $40 low that the stock formed before moving higher. You draw the line from the low to the high. I also will extend my Fib lines to the right so that I can watch for future moves.
It’s obvious that CELG has made a near-term top. We can use the Fibs to help identify a possible level of support. I’ll put the Fib lines on my charts and wait to see if the stock finds support at one of these levels.
Let’s see what happened next.
At first, it looked like the stock was finding good support at the 38.2% level, but it eventually made its way to the 50% retracement level where buyers began to nibble more earnestly. Let’s go forward a few more weeks.
Buying at the 50% retracement level would have made a great entry as the stock took off to new highs from there. The stock trended higher, gave up half of its gains, and then went onto new highs.
I want to point out something on the chart of CELG above, as the stock bounced off the 50% Fib level, the stock also went 3 Green Arrow. Even if you don’t use Fibs, you don’t miss trading opportunities and I want to make it clear, because often, when a stock resumes its upward trend after a retracement, it will go back to 3 Green Arrows, so you don’t really need to use Fibs. They are just another confirmation tool.
Let’s look at some more.
Below is a weekly chart of International Business Machines (IBM). Each candlestick represents a week’s worth of data. As you can see, the retracement principle works on weekly charts just as well as it does on daily charts (in fact, day-traders will use Fibs on 5-minute charts or whatever time frame they use).
The trended began in Jul of 2006, and lasted until October of 2007. IBM would eventually retrace 50% of that move; find support and then move on to new highs.
Our next chart is a daily chart of Gamestop (GME) during late 2007 where the stock enjoyed a nice uptrend. GME would only retrace 38.2% before it began to return to making new highs.
I personally like it when stocks retrace back to the 50% level because I feel that it has shaken out more of the weaker hands, but when a stock only retraced 38.2, it shows that buyers are impatient and can’t wait to get in. You normally get these smaller retracements when a stock is in a powerful trend.
Below is a daily chart of Mosaic Inc. (MOS). There was a sudden and sharp pullback earlier this year that just happened to stop dead at the 50% fib level (see circle) and then shot up to new highs.
Fibonacci levels work on down trending stocks as well. With a down trending stock, you will start your Fib drawing tool at the most recent peak and connect it to the most recent low. What you are doing with these is trying to predict how high the stock will bounce before it begins to move down again. Let’s look at Mosaic Inc. (MOS) once again for an example of this.
You start at the high of about $163. connect to the most recent low. Leave the Fib lines on the chart to see where the buyers run out of steam and where the sellers take control again.
Let’s see what happened over the next several weeks.
The stock came right to the 61.8% retracement level and the rally was finished! You might have noticed that it went a little bit through the 61.8% level by a few dimes, that’s okay. It still worked, and that’s what is most important.
Conclusion
I know this all seems a little complicated and mathematical, but you don’t need to work too hard on this. Just understand that when a stock trends in a direction, it will often take a pause and give back some of that gain. Often, the stock will retrace to one of these Fib levels, where buyers will begin entering and moving the stock to new highs. That’s all you need to understand. The same works on downward trending stocks, often the stock will bounce back up 38.3% or 50% or 61.8% before resuming its downtrend.
Next week, we’ll look more into trading with Fibs.
-Mark Jackman
Stock Investor Personal Coach