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Forex Stock Exchange Forum  » Forex and Stock Trading English Forum » Forex School » Fibonacci Extension Tool

Fibonacci Extension Tool

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1attention Fibonacci Extension Tool Sun Aug 16, 2015 10:36 am


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The Fibonacci extension tool, available in most trading platforms, can help establish profit targets on trending trades or alert a trader to where potential trend reversal areas could develop. Throughout nature we see a repeating pattern, based on a series of “Fibonacci numbers” which Leonardo Pisano Bogollo introduced to the West. The number series is based on the Golden Ratio, a number found in galaxy formations, plant growth and man made structures. These “Fibonacci levels” are also found in financial markets, and can help us determine where the market is going.

Fibonacci Numbers and Fibonacci Extension Levels

When the price of an asset trends higher (called an impulse wave) following a pullback, that impulse wave higher typically has a mathematical relationship to the impulse wave that preceded it. This relationship is based on the “Golden Ratio” and a series of “Fibonacci Numbers” which help define the numerical relationship of one thing to another. The same principle applies to downtrends. An impulse down typically has a mathematical relationship to the impulse wave prior.

As a quick introduction, the following are Fibonacci numbers:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377….

The next number in the sequence is the sum of the prior two numbers before it. The third number is 1, because the prior two numbers–added together–are 0 and 1. The five is a result of adding 2 and 3. 89 is  result of adding 34 and 55. The number sequence can continue indefinitely.

The “Golden Ratio” is derived from this sequence. As the sequence progresses, if a number is divided by the prior number it produces a ratio. 3/2 is 1.5, 13/8 is 1.625. As the numbers progress the relationship (ratio) reaches the Golden Ratio, 1.618. Since the number shows the relationship between an infinite amount of numbers (once the sequence gets going), it also tends to appear throughout nature.

Common Fibonacci Extension levels are 161.8%, 261.8% and 423.6%. As the sequence grows, if you divide a number by the prior number it gravitates toward 161.8%. It doesn’t at the start of the sequence, but as the numbers get bigger, this ratio appears. If you divide a number (once the sequence is well underway) by the number two places before it, the result gravitates toward 261.8%. Dividing a number by the number three places before it results in 423.6%. There are also other Extension levels discussed in the next section.

Fibonacci extension levels (also called Fibonacci Expansion levels) are most accurate on popular and highly liquid currency pairs, stocks and futures contracts. A low volume market is more swayed by individuals (and not a large group of traders) and therefore may have erratic movements which don’t align with the Fibonacci Extension levels.

Using the Fibonacci Extension Tool

There is some interesting history behind Fibonacci numbers, and trading tools utilizing them, but ultimately we don’t need to know this history to trade. The Fibonacci Extension tool is applied to one wave of a price move, which in turn helps to predict where future waves in that trend is will go to and possibly reverse.

I utilize the following Fibonacci extension levels on my chart:

61.8%, 100%, 138.2%, 161.8%, 200%, 238.2%, 261.8%. These Fibonacci Expansion levels are attained by finding relationships between the numbers in the Fibonacci sequence, discussed above, through various calculations.

To use the tool, you’ll need to apply it to you chart; how to do this will vary by trading platform.  In MetaTrader4, go to Insert, then Fibonacci and select Expansion. To apply the tool to an uptrend, click at the bottom of a price wave, and drag the tool to the top of the price wave. You’ll notice the Fibonacci extension has two lines, the first is the one you just drew from the low to the high. The next line is drawn (dragged) to the low of the current retracement.

Figure 1 shows a Fibonacci extension tool applied to a price wave in an uptrend. It starts at the bottom, connects to the top and then the second line of the tool reaches down to the low of the retracement following the wave higher. The tool then helps predict where the next up wave is likely to go–in this case to the 61.8% level, circled on the chart.

Figure 1. EUR/USD Daily Chart with Fibonacci Extension Tool
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Double click on the tool to move it or edit it. Drag the white dots to line them up with the relevant highs and lows in price. You can also right-click on the indicator to bring up the properties of the tool. From there you may need to add some of the Fibonacci extension levels mentioned prior, since they may not all be included by default.

Once you have drawn the tool once, you’re going to need it several more times throughout the day. Instead of going through the menu again, in MetaTrader you can simply click on the tool to select it, then hold down the Ctrl key and left click on the tool. This will duplicate the tool, then you can drag the duplicate to where you need it and adjust it the relevant highs and lows of the new price wave.

The Fibonacci Extension tool can be applied to any market, and any time frame from tick charts to weekly charts and beyond..

Finding Potential Reversal and Target Areas with the Fibonacci Extension Tool

Figure 1 above shows the Fibonacci extension tool applied to an up wave. When the price continues higher it stops very close one of the extension point 61.8, and then reverses.

The level the price stops at will vary depending on the strength of the trend. Most often we see the price pause or reverse at 61.8, 100, or 161.8 of the most recent wave. Once the reversal occurs we can then draw another Fibonacci extension, but we will keep the old one(s) on the chart as well, since down the road there are additional levels which can still be used such as the 200, 238.2, 261.8 and 300.

Figure 2 is the same chart as above, except another Fibonacci extension tool has been added to the next price wave.

Figure 2. EUR/USD Daily Chart with Fibonacci Extensions
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Once the price starts to move higher, we can draw a second Fibonacci extension, as shown in Figure 2. Even with using two tools at the same time, the chart can start to get cluttered. Therefore, we look for areas where the most Fibonacci levels are clustered. Since we are assuming the uptrend will continue, we look for these Fibonacci clusters above the former high.

I have circled a second area in grey, which is where we have three Fibonacci levels in close proximity to one another. The price stalls in this area, and then reverses.

We can continue to repeat this process drawing a new Fibonacci expansion on each new price swing. When the price reverses we  draw the expansion tool to forecast the emerging downtrend.

Figure 3. EUR/USD Daily Chart with Fibonacci Extension
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Figure 2 above shows the expansion tool applied to a downtrend. As the downtrend progresses it reaches more and more of the extension levels, all which could be potential profit target areas for short trades.

Fibonacci Extension Tool Considerations

The tool can be applied to any time frame, from tick charts all up to daily or monthly charts; no matter what timeframe you trade on the application of the tool is the same.

Use the Fibonacci extensions tool to provide profit targets on trending trades. Typically I will use the 61.8 or 100 level, and if the market is moving very strongly I may adjust the target to the 161.8 level. All the levels mark areas where the price could quite possibly stall or reverse, so exit (take profit) slightly before the price reaches the actual extension level.

Fibonacci extension levels indicate potential profit target areas. The price could change direction at these levels as well, but we can’t know that in advance. Therefore, using Fibonacci extension levels for profit targets is preferred to using extension levels in an attempt to predict where a trend will reverse. Trade in the direction of the trend, using extensions as a guide, and forget about trying to predict reversals in advance.

Sometimes the price will charge through the 61.8 level and proceed to the 100 level. Other times it will move right to 161.8 level before stalling. Each level marks an area of potential support/resistance. If the price moves aggressively through a Fibonacci extension level, then it is likely heading toward the next one.

Apply the Fibonacci extension tool to multiple waves, and even different time frames to be aware of different levels which may affect price. For example, apply the tool on a daily chart, and the also apply the tool to your 1, 5 or 15 minute time frame when trading.

Once you’ve draw three Fibonacci extensions, you can start to delete the first ones you drew, since your chart will become too cluttered and you’ll have levels all over the place which is of little value. Also, if your chart is too cluttered, you can delete any old Fibonacci drawings where the price is past the 161.8 level.

How I Use Fibonacci Extension Levels

I rarely use the Fibonacci Expansion tool on my charts. Usually I look at the surrounding price action and base my profit targets on the most common tendencies in the price.

The only time I will use Fibonacci Extension levels is when the recent waves aren’t useful for picking out tendencies. In this case, applying a Fibonacci extension tool to the chart can provide some areas of potential support or resistance which otherwise wouldn’t be visible based on recent price action. My preference is to be in a trade for shortest duration possible (relative to the time frame being traded), so in such cases I will usually opt to take profits at the 61.8% or 100% level and move on to the next trade. This is assuming that taking a profit at one of those levels provides a favorable reward-to-risk ratio (if it doesn’t, I shouldn’t be in the trade in the first place!). If you don’t mind being in trades for longer, and seeking bigger profits, then you can opt to wait for the 161.8% or further out levels.

Using Fibonacci Extensions isn’t required to trade successfully. Use the tool if it helps you; if you find it of little value, never look at it again. Be sure to practice with it and test it out before incorporating it into your trading plan or using real capital.

Final Word on Using Fibonacci Extensions

Use the Fibonacci Expansion tool in all markets and on all time frames. It is a trend following tool, and helps isolate potential profit targets for trades. It can also be used to spot areas where the price could reverse– for this function, don’t place all your trust in it though. The price may not stop exactly at a Fibonacci level, rather the Fibonacci levels are just a guide. We also don’t know if the price will reverse off a Fibonacci level, just stall or only pullback slightly. Sometimes the price will completely disregard Fibonacci levels, often when major news occurs. Don’t try to force a tool to work if it isn’t working for you; you don’t need to use Fibonacci extension levels to trade successfully. Only use the Fibonacci Expansion tool in conjunction with price analysis and as part of a complete trading plan.

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