Do you use Fibonacci ratios in your trading? Like many other technical analysis tools, Fibonacci ratios can be powerful trading indicators that act as self-fulfilling prophecies due to their popularity.
Like price, support and resistance levels, volume, etc., Fibonacci levels are leading indicators. Most traders don’t use Fibonacci levels alone to take trades but combine them with other indicators in their trading system to qualify or disqualify trades.
In this article, I’m going to show you some Fibonacci retracement and extension basics as well as how you might use Fibonacci retracements and extensions in your own trading.
Fibonacci Retracement and Extension Basics
The main difference between a Fibonacci retracement and extension is that Fibonacci retracements are typically used to make a case for entering a trade, whereas Fibonacci extensions are typically used in determining where to take profits.
In the image below, you can see examples of a Fibonacci retracement and extension. To measure the Fibonacci retracement of a bearish swing (like in the example), simply measure from the high of the swing to the low of the swing. To measure the Fibonacci retracement of a bullish move, simply do the opposite (measure from low to high). In other words, measure in the direction of the swing.
Measuring for a Fibonacci extension can vary depending on which tool you use, but the easiest way to do it is to use the regular Fibonacci retracement tool and measure backward (against the swing – as shown in the example above). This creates a Fibonacci projection in the direction of the swing, marking your potential take profit levels accurately.
Note: The MetaTrader 4 platform doesn’t include the 127.2 extension level in the default Fibonacci retracement tool, so you must add 1.272 in the properties of the tool if you want to use that level.
Using Fibonacci Retracements
As I mentioned above, most traders use Fibonacci retracements for qualifying trade entries. If the retracement has only come down to the 23.6 level or less, there is likely to be a further retracement. A very deep retracement (one that retraces further than the 61.8 level) is often a sign that price is not likely to continue in the direction of the original swing.
If you’re waiting to enter a trade on the retracement of a move, there is a sweet spot in which you’d like to see price bounce and hopefully continue the in the original direction. That sweet spot ranges from about the 38.2 level to the 61.8 level.
Note: The 50.0 level is not a Fibonacci ratio, but is usually included in these measurements because price reverses at the 50% retracement level so frequently.
I also mentioned that Fibonacci retracements aren’t usually used alone to enter trades. Rather, they are used in combination with other factors in a trading plan to build a case (or qualify) possible entries.
In the example above, you can see a Fibonacci retracement that was drawn which shows price retracing down to about the 50% level. This wouldn’t be enough to qualify a trade entry on its own, however, the retracement also found support near previous market structure (a previous high).
In the example above, both the support level and the Fibonacci retracement levels are leading indicators. Traders often combine lagging indicators as well, like the stochastic oscillator, RSI, MACD, etc., in search overbought/oversold conditions or even hidden divergence occurring at these specific Fibonacci levels.
Using Fibonacci Extensions
Fibonacci extensions are typically used to project good take profit levels. Some traders also use Fibonacci extensions to qualify certain advanced trading strategies, like harmonic patterns.
The 127.2 and 161.8 extension levels are popular places to take profits or scale out. As a trader, you might move your stop loss to breakeven before price reaches the 100.0 level (the most recent high/low), and then scale out at 127.2, 161.8, etc.
As I mentioned earlier, the easiest way to plot a Fibonacci extension is to measure backward (against the price swing) with the regular Fibonacci retracement tool. In the bullish swing above, I measured from the high of the swing to the low of the swing.
Note: If you decide to use a Fibonacci extension/expansion tool, make sure that you measure with the price swing and then back to your starting point. If you’re unsure whether or not you’re doing it the right way, just compare your levels to the levels of the preferred method that I mentioned above.
Using Fibonacci retracement and extension levels works best after strong and obvious price swings. Don’t try to force things by looking for trades where there are none.
Like any other market indicator, Fibonacci retracement and extension levels are just a tool. Using them will not magically make you a good trader if you’re not already good at trading. However, using them in combination with other market factors can help you filter out some bad trades, which is a good thing for any trader.
As always, be sure to backtest and demo trade any new trading techniques before adding them to your live trading repertoire. Do you use Fibonacci retracement and extension levels in your own trading? Do you use different techniques than the ones I’ve described above? Please let us know in the comments below.