The Fibonacci retracement uses the mathematical sequence known as the Fibonacci sequence to predict market behavior, but its reliability may be overstated. The sequence follows a simple rule, and each number is approximately 1,618 times the previous number, forming the basis of the analysis under the Fibonacci retracement. The theory is that when the value being tracked fluctuates up or down, it will often change direction briefly when it hits one of the values representing the points 61.8%, 38.2%, and 23.6%.
The Fibonacci retracement is a technique used to predict the behavior of the financial market. It is based on a mathematical sequence known as the Fibonacci sequence or the Fibonnaci numbers. The theory is that this sequence reflects the way markets fluctuate and then “correct.” While the Fibonacci retracement is believed by some sources to be effective, its reliability may be overstated, particularly by people selling financial advisory services.
The Fibonacci sequence is named after the mathematician who introduced it to Europe, Leonardo of Pisa. The name is a contraction of filius Bonnacio, or “son of Bonnacio”. The sequence follows a simple rule: each number is the sum of the previous two numbers in the sequence. The first ten numbers in the sequence are 0, 1, 1, 2, 3, 5, 8, 13, 21, and 34. There is a mathematical formula to calculate the sequence without having to step through the list. This formula is the basis of the solution to various mathematical problems.
The use of the Fibonacci retracement is a technique based on another characteristic of the sequence. This is that each number is approximately 1,618 times the previous number. Quite neatly, this also means that each number is 61.8% of the one after it. Similarly, each number is 38.2% of number two in the sequence, and 23.6% of number three places along. These three percentages form the basis of the analysis under the Fibonacci retracement.
Someone using the technique will plot a chart starting with an extremely high and low value for the value being tracked, which will usually be a market index, but could be an individual stock. This high and low will be the highest and lowest figures recorded in the past history period used for analysis and will be recorded on the chart as 100% and 0% respectively. The analyst will then draw vertical lines representing the marks 61.8%, 38.2%, and 23.6%. It is important to note that these percentages refer to the gap between the high and low figures; they do not represent, for example, 61.8% of the highest figure itself.
The theory is that when the value being tracked fluctuates up or down, it will often change direction briefly when it hits one of the values representing the points 61.8%, 38.2%, and 23.6%. In some cases, there may be a general pattern of movement in one direction, but with multiple temporary reversals as each point is reached. Although this pattern is far from guaranteed, most analyzes suggest that it happens all too often by coincidence. The most common explanation is that the gap between each of the points represents the aggregate effect of investors’ psychological response to market movements, particularly the way they try to predict when the market is going to turn.
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