Technicals with ETMarkets: How to use Fibonacci to identify buying levels
Fibonacci is a series of numbers, where a number is found by adding up two numbers before it. Starting with 0 and 1, the sequence goes 0, 1, 1, 2, 3, 5 and so on.
Whenever a stock moves either upward or downward sharply, it tends to retrace its path before the next move.
The Fibonacci sequence is a series of numbers, where a number is found by adding up two numbers before it. Starting with 0 and 1, the sequence goes 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, and so on and so forth till infinity. If we divide any of the number in the series by the previous number; the ratio is always approximately 1.618.
“The ratio of one number divided by the next settles at .618, which is known as the golden ratio. In nature, this is the proportion of a perfect spiral, like that found in a pinecone and a pineapple. This ratio has in turn been correlated to stock price action and enacts retracements and target levels periodically,” Nikhil Kamath, Co-Founder & Director, Zerodha, told ETMarkets.com.
“For instance, if you buy a stock at Rs 100, multiplying it by the ratio gives you a level of Rs 61.8, which could be an effective stop loss. If you multiply this ratio with the stock price, it can give valuable inputs on target levels, stop losses and entry points that can be applied to stock trading,” he said.
Fibonacci ratios i.e. 61.8%, 38.2%, and 23.6% can help a trader identify the possible extent of retracement. Traders can use these levels to position themselves for a trade.
Let’s take this example.
Fibonacci retracements can also be applied to stocks that are falling, in order to identify the levels up to which the stock can bounce back.
In the chart below (Cipla), the stock rose from around Rs 384 level recorded way back in May 2014 to Rs 751 levels in March 2015. (This illustration is only for information and not a recommendation on the stock).
Let’s apply the Fibonacci retracements, when the stock started falling in order to identify levels up to which it can bounce back.
In the chart below (Cipla), the stock started to decline from a high of Rs 751 and broke below key support levels as per Fibonacci series, but finally took support at the 23.6 per cent retracement and bounced back.
Think of a situation where you wanted to buy a particular stock but you have not been able to do so because of a sharp runup in the stock.
In such a situation, the most prudent action to take would be to wait for a retracement in the stock price. Fibonacci retracement levels such as 61.8%, 38.2% and 23.6% act as potential levels up to which a stock can correct.
The first level to watch out would be 61.8 per cent, which provided a strong support for the stock in the past. The stock chart shows that it had bounced back from that level seven times in the past. Hence, a break below that level fuelled further downside in the stock and it went on declining towards 23.6 per cent retracement before moving higher.
Going forward, for a sustained upward move, the stock has to surpass 50 per cent and then 61.8 per cent resistance levels convincingly.
Fibonacci levels closely correspond to the Elliot wave theory, which can be used in addition to the Fibonacci level while making investment decisions.
“Ideally, it should be used as a supporting tool once the decision has already been made using another indicator. Among other indicators, one should use a trend following indicator such as moving average," Rohit Gadia, CEO, CapitalVia Global Research, told ETMarkets.com.
"Fibonacci level is very useful and investors should keep it in mind where the level is before they make an investment. It serves as a great tool to manage risk. However, in a sideways market or a market that is lacking momentum, it may not be that accurate,” he said.