Introduction to Fibonacci Trading
Fibonacci trading is a popular technique among technical traders which is based on key numbers identified by mathematician Leonardo Fibonacci in the 13th century. Fibonacci’s sequence of numbers is not as important as the mathematical relationships, expressed as ratios, between the numbers in the series.
In technical analysis, Fibonacci trading uses horizontal lines to indicate where support and resistance levels should be. The main ratios used in trading are 23.6%, 38.2%, and 61.8%. However, the concept of Fibonacci extensions involves more than just these primary ratios.
Understanding Fibonacci Extensions
Fibonacci extensions are a tool that traders use to establish profit targets or estimate how far a price may travel after a pullback is finished. Extension levels are also possible areas where the price may reverse.
Extensions continue where the Fibonacci retracement left off. It is based on the concept that markets will make a strong move in the direction of the trend, followed by a period of retracement, or backward movement, before the original trend is resumed.
How to Use Fibonacci Extensions in Trading
Step 1: Identify Swing Points
Firstly, you need to identify the swing points to draw the Fibonacci levels. The swing high is the highest point on the graph in the time frame you are concerned with. The swing low is the lowest point, similarly, in the same time frame.
Step 2: Draw the Fibonacci Levels
Using the Fibonacci tool in your trading software, draw a line from the swing high to the swing low. This will automatically calculate and draw the Fibonacci retracement levels for you.
Step 3: Use the Extensions
The Fibonacci extension levels are derived by multiplying the length of the price action (distance from swing high to swing low) by the Fibonacci ratios of 61.8%, 100%, 161.8%, 200%, and so on. These levels provide potential targets for both trend continuation and counter trend moves.
Interpreting Fibonacci Extensions
Fibonacci extensions are not meant to be the sole determinant of whether to buy or sell a security. Instead, they provide an expectation of where the price could potentially reach.
For example, if the price retraces 38.2% and then resumes the trend, the Fibonacci extension tells us how far the price could go. If the price retraces to the 61.8% level, then we might expect it to extend to the 161.8% level.
Conclusion
Fibonacci extensions are a powerful tool in a trader’s arsenal, providing potential targets for both trend continuation and counter trend moves. Like any trading strategy, it’s important to use Fibonacci extensions in conjunction with other forms of analysis and to use proper risk management techniques.
