From The Free Forex Encyclopedia
Markets move in rhythms. An impulse wave that defines a major market trend will have a corrective wave before the next impulse wave reaches new territory. This occurs in either bull market or bear market conditions. The most common approach to working with corrections is to relate the size of a correction to a percentage of a prior impulsive market move. In regards to the 3-wave patterns, Fibonacci Retracement indicates how far a corrective wave B could go before wave C is born. The first support level is the one marked by 38.2% and if price moves through it then it becomes a resistance line and a new support level shifts to Fibonacci level of 61.8%.
Fibonacci retracements are one of the four most commonly-used Fibonacci studies for predicting levels of support and resistance for a given market. Fibonacci retracements are used immediately after a strong price movement either up or down. An imaginary vertical line is drawn across the chart between two extreme price values, one high and one low. Then a number of horizontal lines are drawn perpendicular to the imaginary vertical at significant Fibonacci values. The most common number of lines is five, drawn at 0%, 38.2%, 50%, 61.8%, and 100% of the length of the line (starting from either end), but some traders have been known to use even more retracement lines than this.
Following a strong price movement in either direction, markets tend to "retrace" much of their change in price, and the levels at which this retracement reverses or pauses often correspond with the horizontal lines on the Fibonacci retracement chart. A Fibonacci retracement isn't useful for determining overall trends in price, but can help to predict levels of support and resistance within a large price reversal, allowing traders to anticipate medium-sized fluctuations in price and trade accordingly.