What are Fibonacci extensions?
Fibonacci extensions are a tool that traders can use to set profit targets or estimate the distance a price can travel after the end of a retracement / withdrawal. Extension levels are also possible areas where the price can be reversed.
The extensions are drawn on a graph, marking the price levels of possible importance. These levels are based on the Fibonacci ratios (in percentage) and on the size of the price movement to which the indicator is applied.
Key points to remember
- The common Fibonacci extension levels are 61.8%, 100%, 161.8%, 200% and 261.8%.
- The Fibonacci extensions show how far the next price wave could move following a setback.
- Fibonacci ratios are common in everyday life, seen in galactic formations, architecture, as well as the growth of certain plants. Therefore, some traders believe that these common ratios may also be important in the financial markets.
- Extension levels indicate possible important areas, but should not be used exclusively.
The Fibonacci extensions formula
Fibonacci extensions have no formula. When the indicator is applied to a chart, the trader chooses three points. Once the three points have been chosen, the lines are drawn in percentages of this movement. The first point chosen is the start of a stroke, the second point is the end of a stroke, and the third point is the end of the retracement against that stroke. Extensions then help predict where the price might go next.
How to Calculate Fibonacci Retracement Levels
- Multiply the difference between points one and two by one of the desired ratios, such as 1.618 or 0.618. This gives you a dollar amount.
- If you are projecting a higher price, add the above dollar amount to the price in point three. If you are projecting a price decrease, subtract the dollar amount from the first step of the price in point three.
For example, if the price goes from $ 10 to $ 20, down to $ 15, $ 10 could be point one, $ 20 point two and $ 15 point three. Fibonacci levels will then be projected above $ 15, providing levels higher than the next price development. If instead the price drops, the indicator should be redrawn to account for the price below point three.
If the price goes from $ 10 to $ 20 and these two price levels are points one and two used on the indicator, the 61.8% level will be $ 6.18 (0.618 x $ 10) above- above the price chosen for item three. In this case, point three is $ 15, so the 61.8% extension level is $ 21.18 ($ 15 + $ 6.18). The 100% level is $ 10 above point three for an extension level of $ 25 ((1.0 x $ 10) + 15).
The ratios themselves are based on something called the Golden Ratio.
To learn more about this report, start a sequence of numbers with zero and one, then add the previous two numbers to finish with a string of numbers like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987 …
The Fibonacci extension levels are derived from this numeric chain. Excluding the first numbers, as the sequence progresses, if you divide a number by the previous number, you get a ratio approaching 1.618, such as dividing 233 by 144. Divide a number by two places on the left and the ratio approaches 2.618. Divide a number by three on the left and the ratio is 4.236.
The 100% and 200% levels are not official Fibonacci figures, but they are useful because they project a movement similar (or a multiple of it) to what just happened on the price chart.
What do Fibonacci extensions tell you?
Fibonacci extensions are a way of setting price targets or finding projected areas of support or resistance when the price moves to an area where other methods of seeking support or resistance are not applicable or obvious.
If the price goes from one level of extension, it can continue to move to the next. That said, Fibonacci extensions are possible interest. The price may not stop and / or reverse right at the level, but the area around it may be large. For example, the price may exceed the 1.618 level or go up just before changing direction.
If a trader is long on a stock and a new high occurs, the trader can use the Fibonacci extension levels to get an idea of where the stock can go. The same goes for a trader who is short. Fibonacci extension levels can be calculated to give the trader ideas on how to set the profit target. The trader then has the option of deciding whether or not to hedge the position at this level.
Fibonacci extensions can be used for any period or in any market. Typically, clusters of Fibonacci levels indicate a price area that will be important for the stock, as well as for traders in their decision making. Since extension levels can be drawn on different price waves over time, when multiple levels of these different waves converge at one price, this could be a very important area.
The difference between Fibonacci extensions and Fibonacci retracements
While the extensions indicate where the price will go after a retracement, the Fibonacci retracement levels indicate the depth of a retracement. In other words, Fibonacci retracements measure the withdrawals within a trend, while Fibonacci extensions measure the pulse waves in the direction of the trend.
Limitations on the use of Fibonacci extensions
Fibonacci extensions are not meant to be the only determinant for buying or selling a stock. Investors are advised to use extensions with other indicators or models when seeking to determine one or more price targets. Candlestick patterns and price action are particularly instructive when trying to determine if an action is likely to reverse at the target price.
There is no assurance that the price will reach and / or reverse at a given level of extension. Even if this is the case, it is not obvious before an exchange is taken what level of Fibonacci extension will be important. The price could easily go through several levels or not reach one of them.