The Fibonacci series is a sequence of numbers starting from zero arranged in such a way that the value of any number in the series is the sum of the previous two numbers.
The Fibonacci sequence is as follows:
0 , 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610…
Divide any number in the series by the previous number; the ratio is always approximately 1.618.
610/377 = 1.618
377/233 = 1.618
233/144 = 1.618
Further into the ratio properties, one can find remarkable consistency when a number is in the Fibonacci series is divided by its immediate succeeding number.
89/144 = 0.618
144/233 = 0.618
377/610 = 0.618
At this stage, do bear in mind that 0.618, when expressed in percentage is 61.8%.
Similar consistency can be found when any number in the Fibonacci series is divided by a number two places higher.
13/34 = 0.382
21/55 = 0.382
34/89 = 0.382
0.382 when expressed in percentage terms is 38.2%
Also, there is consistency when a number in the Fibonacci series is divided by a number 3 place higher.
13/55 = 0.236
21/89 = 0.236
34/144 = 0.236
55/233 = 0.236
0.236 when expressed in percentage terms is 23.6%.
Relevance of Fibonacci ratios in stock market
It is believed that the Fibonacci ratios i.e 61.8%, 38.2%, and 23.6% finds its application in stock charts. Fibonacci analysis can be applied when there is a noticeable up-move or down-move in prices. Whenever the stock moves either upwards or downwards sharply, it usually tends to retrace back before its next move. For example if the stock has run up from Rs.50 to Rs.100, then it is likely to retrace back to probably Rs.70, before it can move Rs.120. ‘The retracement level forecast’ is a technique using which one can identify upto which level retracement can happen. These retracement levels provide a good opportunity for the traders to enter new positions in the direction of the trend.
The Fibonacci ratios i.e 61.8%, 38.2%, and 23.6% helps the trader to identify the possible extent of the retracement. The trader can use these levels to position himself for trade
How should you use the Fibonacci retracement levels?
Think of a situation where you wanted to buy a particular stock but you have not been able to do so because of a sharp run up in the stock. In such a situation the most prudent action to take would be to wait for a retracement in the stock. Fibonacci retracement levels such as 61.8%, 38.2%, and 23.6% act as a potential level upto which a stock can correct. By plotting the Fibonacci retracement levels the trader can identify these retracement levels, and therefore position himself for an opportunity to enter the trade. However please note like any indicator, use the Fibonacci retracement as a confirmation tool.
I would buy a stock only after it has passed the other checklist items. In other words my conviction to buy would be higher if the stock has:
1. Formed a recognizable candlestick pattern
2. The stoploss coincides with the Support & Resistance level
3. Volumes are above average
Along with the above points, if the stoploss also coincides with the Fibonacci level then I know the trade setup is well aligned to all the variables and hence I would go in for a strong buy. The usage of the word ‘strong’ just indicates the level of conviction in the trade set up. The more confirming factors we use to study the trend and reversal, more robust is the signal. The same logic can also be applied for the short trade.