Since stock and option trading revolve around the basic concept of “Buy low and sell high” in order to make a profit, knowing when a stock would likely fall after bullish price movements and knowing when it would rise after bearish movements could spell huge profits to a trader. This is why Fibonacci retracements could really come in handy.
The Fibonacci Retracement is based on Leonardo Fibonacci’s introduction of the Fibonacci sequence during the twelfth century. However, the most remarkable part about the Fibonacci sequence is not the sequence itself but the relationship between one number to the next. There always seem to be a fixed ratio between the numbers in the Fibonacci sequence. Interestingly, the ratio in the Fibonacci sequence has been found out to govern a lot of things around the world such as the shape of the human form, the proportions of the Parthenon, the proportions of spirals in sunflowers, etc. This ratio has been coined as the “Golden Ratio”
As it turns out, many traders over the decades have observed that the rise and fall of stock prices also seem to be governed by the Golden Rule. In particular, investors have observed that based on the Golden Rule, the support and resistance levels of a stock can be determined with a modest to high precision. Hence, Fibonacci Retracements are used as a tool to determine the support and resistance levels of a stock.
Fibonacci Retracements are quite easy to make. In a candlestick chart or any graph that has recorded the price changes of a stock for a given period, first select the highest and lowest points which the price has reached for the given period. For the highest point, draw a horizontal line and label it as 100%. For the lowest point, draw another horizontal line and label it as zero percent. Also, draw horizontal lines that would correspond to 61.8%, 50% and 30.2% in the graph. Your graph should somehow look like the one below.
Some trading systems include a feature that allows you to set Fibonacci Retracements while tracking the stock.
In interpreting Fibonacci Retracements, the most important horizontal lines that you should focus on are the lines between 100% and 0%.
The 61.8% and 38.2% lines reflect the support and resistance levels. These are the levels at which price reversals mostly occur. For example, if a price moves from the 0% up to 61.8% on a straight diagonal line, a sudden drop from the 61.8% retracement level can be reasonably expected. When the price continues to fall down and approaches the 38.2% retracement level, it will not be unlikely that a sudden reversal in the stock price could occur.
Price reversals at the support and resistance levels do not happen all of the time but is has been observed that, for most cases, reversals happen at or near these price levels.
Furthermore, the 50% retracement level is also important because there is an overwhelming tendency for a stock price to continue on a certain direction if it passes through the 50% retracement level.
Knowing when a stock price would reverse or continue its direction can certainly give you the advantage you need in buying and selling stocks and options to lock yourself with profits.
No one knows for sure how the Golden Rule affects so many things around the world. Many professionals say that the Golden Rule is just one of the mysteries of nature that cannot be truly be explained but only observed. For a trader like you, you can use the Golden Rule and turn it into gold, then rule.
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