How to use Fibonacci retracements and extensions?

Fundamental to understanding the golden ratio and other methods to describe the natural world, the Fibonacci sequence was popularized in the West by Leonardo Pisano Fibonacci, an Italian mathematician from Pisa who lived at the turn of the 13th century.

You probably remember this from your school days. The Fibonacci sequence starts as follows: 1, 1, 2, 3, 5, 8, 13 and so on, where each number is the sum of the two preceding numbers. Imagine a zero at the beginning to get started, e.g. 0+1=1, 1+1=2, 1+2=3, 2+3=5, and so on.

The sequence has numerous applications in many fields of science. In technical analysis, however, it is most commonly encountered in the Fibonacci retracement and Fibonacci extension tools.

FIBONACCI LEVELS ESSENTIALS

• Fibonacci levels are based on the so-called Fibonacci sequence.
• Fibonacci levels can be utilized to identify support and resistance zones on a trading  chart.
• The Fibonacci retracement tool draws retracement levels between the swing high and swing low.
• These levels include 0.236, 0.382, 0.618 and 0.786.
• While not a Fibonacci ratio, 0.5 is also an important retracement level, while 0 and 1 serve as anchors of the Fibonacci retracement tool.
• The Fibonacci extension tool draws extension levels past the swing high or swing low.
• These levels most frequently include 1.236, 1.382, 1.5, 1.618 and 2.618.

Swing high and swing low

To use the Fibonacci levels properly, we must first learn how to identify the co-called swing highs and swing lows.

• A swing high is a high with two lower highs on the sides.
• A swing low is a low with higher lows on the side.

When applying Fibonacci levels to a chart, these two points are where we need to place the tool’s anchors (1 and 0).

There are many swing highs and lows on the charts. When we decide which ones to choose for applying the Fibonacci levels, it is wise to pick the most obvious options - those that really stand out.

When it comes to choosing time frames, longer durations give us more reliable Fibonacci levels. However, this tool is often used for short-term trading, which means that shorter time frames are often preferred.

Fibonacci retracement

Among the most popular Fibonacci levels are Fibonacci retracement levels, which help identify potential support and resistance zones. These levels are often used to identify entry (buy) and exit (sell) points, or to decide where to put a trigger for stop orders. These are automatically executed when a certain price is reached, preventing significant losses in the process.

Each level of Fibonacci retracement is associated with a set percentage, which is derived from the Fibonacci sequence. The percentage tells how much of a prior move the price has retraced.

These percentages are 23.6%, 38.2%, 61.8% and 78.6%. Converted into decimal values, the Fibonacci retracement levels are 0, 0.236, 0.382, 0.5, 0.618, 0.786 and 1.

0 and 1 are the anchors for Fibonacci retracement levels and represent the swing high and swing low. While not an actual number in a Fibonacci sequence, 0.5 is also considered an important retracement level.

Identifying support levels

When using Fibonacci retracement levels to identify support, we are attempting to predict where the price may retrace to after moving up. In other words, we’re identifying where the price might land after it has reached a peak and started declining. This could provide us with promising buy points.

To set up the anchors of Fibonacci’s retracement correctly when looking for support levels, we must put the first anchor of Fibonacci retracement at the swing low (number 1) and the second anchor at the swing high (number 0).

The retracement levels are spread between the 1 and the 0 (the levels are 0.236, 0.382, 0.5, 0.618 and 0.786). Each of these levels represents potential support on the chart.

Identifying resistance levels

Fibonacci retracement levels can also be used to identify resistance levels. In this case we’re trying to predict where the price may retrace to after a move down. These could provide us with good sell points.

In this case, we put the anchors in the opposite order: first we choose the swing high and then the swing low. Number 1 should be located at the top of our chart and number 0 at the bottom. Resistance levels are spread between them at 0.236, 0.382, 0.5, 0.618 and 0.786.

Utilizing Fibonacci retracement

Fibonacci retracement levels can be used to identify your entry points (support level), to set your exit points (resistance levels), or to decide where to put your stop-loss order. The usual method for limiting losses with a stop order is placing the stop order slightly below a Fibonacci level.

For example, if you used Fibonacci retracement to find support levels and your entry point is at the 0.5 Fibonacci level, then a stop loss can be placed slightly below 0.618 or 0.786. If your entry point is at 0.618, stop loss can be placed below 0.786 or 1 (the swing low).

Fibonacci extension

Fibonacci extension levels are not used as much as retracements, but they are still worth examining. As opposed to Fibonacci retracement levels, which are spread between the swing low and swing high, Fibonacci extension levels reach past the swing high or swing low.

They are used to identify potential resistance levels exceeding the swing high or to identify support levels below the swing low. They are, however, much more speculative than the Fibonacci retracement levels. The most commonly used Fibonacci extension levels are 1.236, 1.382, 1.5, 1.618 and 2.618.

Fibonacci levels are a fairly useful trading tool with various usages. They can be used to identify support and resistance levels and also potential targets past new highs or lows. As is the case with other indicators, the use of Fibonacci retracement is highly subjective.

That being said, many traders use Fibonacci retracement in combination with other indicators and technical signals, demonstrating its effectiveness when used correctly.