Using Fibonacci Retracement Levels on thinkorswim®

Leonardo Fibonacci was an Italian mathematician who helped popularize the study of what is now known as the Fibonacci sequence. The sequence is tied to the golden ratio, which shows up repeatedly in the natural world in the shape of snail shells, pinecones, and the spin of hurricanes. So, what does the ratio for the spiral on a pinecone have to do with stock prices? 

Many technical traders guide their trading by using chart drawing tools like Fibonacci retracements and Fibonacci extensions, which are based on ratios from the Fibonacci sequence. They “follow the Fib” to predict potential price movements, looking for buy and sell opportunities.

The Fibonacci sequence represents a series of numbers in which a given number is equal to the sum of the two preceding numbers:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, etc.

The numbers were used long before Fibonacci's time, and the sequence is ultimately less significant than the ratios derived from dividing the numbers into one another. For example, 13/8 = 1.625. As you move up the sequence, to say 55/34, the ratio approaches the number 1.618—what is famously known as the golden ratio and observed by people as far back as the Greek mathematician Euclid. 

For traders, other ratios from dividing the number have potential value, like the inverse of the calculation for the golden ratio: 34/55, or 0.618. Studies about how the ratios may relate to markets began being developed decades ago.

In the 1930s, Ralph Nelson Elliott developed his Elliott Wave Theory, which looked at long-term market trends based on the Fibonacci sequence. His analysis found that market trends tend to follow a pattern of five waves on the direction of the trend, followed by three corrective waves.  It looked at price movements along ratios found in the Fibonacci sequence, including 23.6%, 38.2%, 61.8%, and 161.8%. The 38.2% comes from dividing any number in the Fibonacci series by the number found two places to the right, and 23.6% comes from dividing a number by the number found three places to the right. 

The 50% and 100% levels aren’t derived from the Fibonacci numbers, but many traders consider these significant levels. Some traders use additional numbers that come from the midpoint of two of these numbers.

Fibonacci ratios can help technical traders identify areas of support, resistance, and retracement. When a stock moves off its peak or trough levels, traders want to know where it might go next. Tools on the thinkorswim^® platform apply the Fibonacci numbers to a chart to show where the support and resistance levels may be.

In the chart of the S&P 500^® index (SPX) above, the top level is 100% and the bottom level is 0%. The retracement levels in between are areas traders can watch for potential technical support or resistance levels. Fibonacci retracements can also be used in the opposite way, from a low point to a high point (as long as the high point is to the right of the low one). In this scenario, retracing a move higher, the Fibonacci series frequently acts as key points of support in the pullback or correction.

When the SPX started to move above its March low, it met slight resistance at the 23.6% level. Even though it broke above it, the close was right around that level. The SPX then continued moving toward the 38.2% level, hesitated there for a few days, and then went back toward the 23.6% level. When reviewing the price chart, it's possible to see how the different retracement levels acted as support and resistance levels.

Traders can try applying this tool to individual stocks. It's also possible to combine Fibonacci levels with other indicators to get more trading signals.

Fibonacci retracements are accepted and used by many traders, including some who trade for large institutions and hedge funds. There's no guarantee that using Fibonacci retracements will work effectively as part of a trading strategy, but they can provide some levels to watch when engaging in technical analysis.

After becoming familiar with the Fibonacci sequence and understanding how to use retracements in trading, traders can also explore some lesser-known technical tools to add to their trading toolbox.