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Applying The Golden Ratio To Technical Analysis – Fibonacci Retracement Part 1
Education | 12 July 2013
By: Shane Goh
Articles (99) Profile

In the face of market volatility, having a tool to provide you with potential support and resistance prices along with key reversal pivots could help keep you on the favorable side of the trend.

Global stock markets have taken a hammering since 23 May, when Ben Bernanke mentioned a potential tapering of the Federal Reserve’s quantitative easing plans, led by indices such as the Nikkei which shed 11.8 percent as of 3 July. Firms with traditionally sound fundamentals have not come away unscathed as exemplified by the decline of SingTel by 13.2 percent at its lowest since the comment.

Enter the famed Leonardo Fibonancci’s sequence (1, 1, 2, 3, 5, 8, 13, 21, etc), where a golden ratio of approximately 1.618 is derived by dividing a number in the sequence with its preceding number.

The golden ratio phenomenon is witnessed worldwide in the arrangement of branches along the stems of plants, Leonardo Da Vinci’s Vitruvian Man and nature’s smallest building blocks, such as atoms. The stock markets also exhibit patterns which adhere to the mathematical premise of the ratio, known as Fibonacci retracements.

You may begin plotting the Fibonacci retracement by drawing a vertical line from the top or bottom of the chart, depending on the direction of the trend and your preferred timeline. The start of the line is determined at 100% while the end is 0%. In Figure 1, we observed a downward trend and drew a vertical line from the level of point A (top) to point B (bottom). From the end of the vertical line (point B), you will work backwards to draw horizontal lines, representing the various Fibonacci-significant percentages of the initial vertical’s length (38.2%, 50% and 61.8% of the vertical’s length being the most common values used.) However, additional multiples can be used when needed, such as 23.6%.

Figure 1: Day Chart For GoldenAgr

Source: FactSet

As many technical traders refer to the retracement levels for support and resistance levels, stocks will trade heavily around those points. Once a Fibonacci level is met and broken through, that level becomes a support/resistance, with the following Fibonacci level becoming the next barrier. Crossing the 50% retracement level is considered a reversal in trend and price will have a tendency to follow through with the change with the piercing of the 61.8% as a confirmation signal.

In the day chart for SingTel (Figure 2), we have illustrated an example of drawing a Fibonacci retracement on a candlestick chart. We observed a high at point A and a low at point B. By plotting a 100% at the peak (A) and a 0% at the bottom (B), we will be able to calculate the potential retracement levels for the stock.

As we track the movements on the chart, we noticed that the price broke the retracement level of 38.2% (point C) fairly easily but met resistance at 61.8% (point D), attempting to break the level on more than one occasion. However, as it was unsuccessful, the price began its descend once more, only to meet a support at the 38.2% level (point E). As the price tested the 38.2% twice, it found a support and commenced its ascent, eventually stopping at the next barrier of 100% (point F). A minor correction took place as the price fell to the 61.8% level once again (point G). Upon finding its feet, the counter took off once more, breaking pass the 100% mark at point H convincingly and completing a full rebound.

Figure 2: Day Chart For SingTel

Source: FactSet

With the advancement of technology, drawing Fibonacci retracement has become much easier with most technical software possessing this simple tool. As with most technical indicators, Fibonacci retracements are usually used in conjunction with other indicators such as moving averages or trend lines, which will be touched on in the next part of our series.

As a rule of thumb, readers should apply the Fibonacci retracement lines for a duration similar to the length used to plot them. If the lines drawn are for a period of three months, we should allow the analysis to be used for the “forward looking three-month horizon”.

Currently pursuing his Chartered Financial Analyst qualification, Shane provides coverage on the property, consumer and environmental sectors at Shares Investment.

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