Technical Analysis: Why Fibonacci Retracement Levels are Essential

Bollinger Bands. Relative Strength. The Golden Cross. Cup and Handle Patterns.

These are just a handful of terms associated with technical analysis. The idea behind this style of trading is based on two key ideas.

First, Stock Prices Move in Trends

For a technical analyst, the trend is always his friend. That's why most technical trading strategies are trend following. That includes the broader market trends as well as those of individual stocks. Once a trend has been established, technicians know that the future price movement will likely continue in the same direction. Of course, any break in this trend is often where technicians decide to sell

And second, Markets -- Like People -- Repeat Themselves.

Technicians believe that since markets are made up of people, they follow predictable patterns.

The belief is that once a consistent pattern of behavior has been established it can be used in the future to provide good entry and exit points.

The ability to notice these things – which drive fear and greed – allow us to use technical analysis. As technicians have learned from Jesse Livermore, for example, “The price pattern reminds you that every movement of importance is but a repetition of similar price movements, that just as soon as you can familiarize yourself with the actions of the past, you will be able to anticipate and act correctly and profitably upon forthcoming movements.”

Technicians know that certain chart formations and patterns can dictate market psychology of stocks and markets at key points. A trader attempts to understand and identity support and resistance levels to successful trade.

In addition, the beauty of such analysis is that it can help dictate excessive fear and greed in the markets. In fact, we’ve proven that with Bollinger Bands (2,20), MACD, relative strength (RSI), Williams’ %R (W%R) and with Money Flow (MFI).

However, there’s another key technical tool to understand.


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The Fibonacci Retracement Levels.

Retracement levels are based on the belief that stocks, currencies and indices tend to retrace their paths after a big move in a single direction.  You first find your two extremes – a peak and a trough – and then divide by key Fibonacci ratios, such as 23.6%, 38.2%, 50%, 61.8%, and 76.4%. All are used to forecast the extent of a potential pullback or move higher.

At each level, we draw a horizontal line to define points of support and resistance.

The goal is to help traders determine critical points where a stock, or index may move up or down based on prior levels of support and resistance.

We can illustrate this with the Dow Jones Industrial Average (DJIA), for example.

We begin by finding our peak and trough. We then draw our horizontal lines, which help us identify areas of support and resistance. We can then begin to see the critical points at which the stock has found support and resistance since July 2019 for example.

Notice how the retracement levels clearly define support and resistance points along the way.

For example, the DJIA found heavy resistance after testing its 50% retracement line, or we can see that it caught support at 0% retracement three times now.

The question then becomes, “should such an indicator be used alone?”

And the answer is always, “no.” 

That’s because retracements are not an exact science.  It’s simply showing us history.

There will never be a time when it’s okay for one technical indicator to be used. Instead, to get a fuller picture, use retracements with other tools such as Bollinger Bands, relative strength (RSI), MACD, Money Flow (MFI), or even Williams’ %R (W%R).

It’s just another strong tool to keep in your trading arsenal.

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