The Fibonacci Retracements are ratios that are used to identify potential support and resistance levels. These levels are potential reversal points for us to pay extra attention to for a return to the prior trend.
The retracements are based off of a mathematical sequence shown below:
1,2,3,5,8,13,21,34,55….. where the prior 2 numbers are added together to get the next number in the sequence.
If you take a number and divide by the next highest number in the sequence, the answer nears .618 (8/13 = .6153, 13/21 = .619……) as the numbers get higher. As a percentage .618 = 61.8%
If you take a number and divide by the number that is 2 places higher in the sequence, the answer nears .3820 (8/21 = .3809, 13/34 = .3823……) as the numbers get higher. As a percentage .382 = 38.2%
Another retracement level is 23.6%. The fourth common retracement is 50% which is the only retracement not based on the Fibonacci sequence. The 50% retracement is based off the Dow Theory that the Dow Jones Industrial Average often retraces half of their previous move.
An example of the EURJPY daily chart is shown below:
The retracement tool is based on picking the beginning of a move and then the end of the move. The dashed redline shows the connection between starting and endpoints. The yellow lines show the different retracement levels. Notice how the pair pulled back to these points of temporary support after hitting its peak. These are also the key levels where the pair could return to its upward trend. If it were to return to an upward trend, it would have to break through the next level up which would be acting as a resistance level. The retracements also work the same way in a downward trend, where a bounce could be expected to find resistance at the same percentage numbers.
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