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Fibonacci Retracements and Extensions
What are Fibonacci numbers?
Fibonacci numbers are a numerical sequence in which each number is the sum of the previous two numbers. The sequence begins 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, etc…
A defining characteristic of the Fibonacci sequence is that each number is approximately 1.618 times greater than the preceding number. This ratio (along with its inverse, 0.618) has many names, among them, the golden ratio. Intriguingly, it is a ratio appears frequently in nature as the proportion of the relationships between various component building blocks. For instance, the leaf arrangements in plants adhere to Fibonacci ratios, as does the proportion of male bees to queen bees in a hive. Similarly, the relationship between the parts of the human arm (try dividing the distance from your shoulder to your fingertips by the distance from your elbow to your fingertips) respects the golden ratio. The list of examples goes on and on. But what does this have to do with trading?
Application of Fibonacci numbers in trading
It’s certainly a fact that Fibonacci ratios are widely used in trading, and perhaps nowhere are they more popular than in the Forex market. One argument by those who use them is that Fibonacci ratios are relevant to the markets because changes in price reflect human expectations. Since human expectations are naturally occurring, they ought to adhere to Fibonacci ratios.
Whether or not you buy this line of thinking, there is another argument in favor of using Fibonacci in your trading that you should be aware of and respect: Large numbers of traders watch Fibonacci levels and act in unison when price reaches them. As a result, this anticipation of how price will behave often becomes a self-fulfilling prophesy.
You don’t want to get caught unawares when price reaches a significant Fibonacci level that is being closely watched by Forex traders around the world. That could do serious damage to your trading account.
It’s much better to take the opposite tack. Educate yourself on the use of Fibonacci concepts and learn to trade them knowledgeably and skillfully.
At Currency Ninjas, we use Fibonacci extensively in our trading. In fact, advanced Fibonacci training is a core part of our Premium Education program.
Fibonacci basics
Now that you understand why Fibonacci is important in trading, let’s go on to look at the basic Fibonacci concepts every trader should know.
The Fibonacci ratios used most commonly in technical trading are 38.2%, 50% and 61.8%. Less commonly used ratios include 23.6%, 0.786%; 0.886%, 1.27%., 161.8% and 261.8%.
The primary applications of these ratios are in estimating potential price retracement and extension levels. These levels are then used for entries, profit exits and stops.
Trading Fibonacci Retracements
Whenever price moves up or down and then begins to retrace, the question arises: where will the retracement find support or resistance?
To determine potential Fibonacci retracement levels, the first step is to identify the high and low of the move. Next, divide the distance by the key Fibonacci ratios and mark the levels on your chart. Most trading platforms provide built-in tools that enable the trader to execute this process quickly and easily.
In a strong trend, price will often retrace only as far as the 38.2% level before finding support or resistance. The next key level is the halfway mark, the 50% Fibonacci level.
A deep retracement to the 61.8% level is a clear indication of a weakening trend. If this happens, stay alert for further signs that the trend you are in could be nearing its end. If price breaks through and closes beyond 61.8% level, you may consider taking a stop loss and shifting your trade bias to the opposite direction.
Trading Fibonacci Extensions
Whenever price breaks out beyond a significant high or low, the question arises: how far will it go before pausing or reversing? The answer to this question is critical because it will help you determine where to take profit on the trade.
One of the methods traders employ to identify good areas to take profit is to calculate the Fibonacci extension levels. Popular levels include the 127%, 161.8% and 261.8%. To determine potential Fibonacci extension levels for a given price movement, first identify the high and low of the move. Next, calculate the Fibonacci extension levels in the direction of the move.
Again, most trading platforms provide built-in tools that enable the trader to execute this process quickly and easily.
3 Rules to Follow
- The most reliable ratios tend to be the 38.2% and 61.8%.
- Fibonacci retracement levels should be used only in combination with other levels and indicators to increase the probability of success.
- If a Fibonacci level is broken by price action, consider it negated and do not use it further in your trade analysis.
Final thoughts
Fibonacci is different than most other technical indicators in that it is forward looking. While indicators such as the MACD, RSI or Stochastic are based on an average of past prices, Fibonacci looks to the future and suggests potential entry, stop and take profit levels.
This is an important distinction and helps explain why Fibonacci has become such a popular trading tool. It is prudent to use Fibonacci only in combination with other levels and indicators. This will increase the probability of success.
If a Fibonacci level is broken by price action, we suggest that you consider it negated and do not use it further in your trade analysis.
Good luck in your trading!
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