How to Use Fibonacci Retracement and Extension Levels in Trading

If you’ve ever traded in financial markets, chances are you’ve come across Fibonacci retracements. 

This technical indicator, inspired from Leonardo Fibonacci, a medieval Italian mathematician, has unexpectedly influenced the trading world for over 800 years.

Originally related to a sequence used to model rabbit population growth, Fibonacci retracements and extensions now help traders in identifying potential buy and sell points.

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Understanding Fibonacci Levels

Fibonacci levels are popular tools in technical analysis that highlight potential support A price level on a chart where buying interest is strong enough to prevent the price from falling further. It indicates where an asset tends to stop and potentially reverse its downward movement. and resistance A price level on a chart where selling interest is strong enough to prevent the price from rising further. It marks where an asset tends to stop and potentially reverse its upward movement. areas on price charts. Based on the Fibonacci sequence, these levels can help traders spot where prices might pause or reverse.

When the market retraces or continues in its trend, Fibonacci levels can show potential buy or sell zones. While not perfect on their own, using them with other analysis tools can add more precision to a trading strategy.

It’s important to distinguish between Fibonacci retracements and Fibonacci extensions:

• Retracements identify potential levels where a price might pull back within a trend before continuing in the same direction.
• Extensions, on the other hand, project beyond the initial price movement and help traders set target prices for trend continuation after a retracement.
  

By combining Fibonacci retracement levels with extension ratios, traders can effectively plan entries, exits, and profit-taking points for higher accuracy and confidence in their trading strategies.

Fibonacci Retracements and Their Best Uses

Fibonacci retracements highlight potential points where a security’s price might pause or reverse after a strong move. They give traders insight into how far a market might pull back before resuming its trend, helping to spot strategic entry points during a correction.

Example of a Retracement during an Uptrend:

• If the initial trend is upward, these retracement levels may act as support during a price correction and potentially offer buy signals to traders.
• If the initial trend is downward, these retracement levels may act as resistance during a price rebound and potentially offer sell signals to traders.

Fibonacci Retracement Level	Common Usage
23.6%	First minor retracement level
38.2%	Moderate retracement, common for shallow pullbacks
50%	Psychological midpoint, not a Fibonacci ratio but widely used
61.8%	The “Golden Ratio,” key retracement level
76.4%	Deeper retracement, used less frequently

Fibonacci Extension Levels and Their Best Uses

Fibonacci extensions are used to identify potential endpoints of a price movement following a retracement. They help predict where the price might go next, especially when it extends beyond its previous highs or lows.

Example of an extension during an uptrend:

• If the initial movement is upward, Fibonacci extension levels will likely act as resistance during a new upward price impulse. These levels may provide sell signals for traders.
• Conversely, if the initial movement is downward, Extension levels are likely to serve as support during a new downward price impulse. These levels may provide buy signals for traders.

Fibonacci Extension Level	Common Usage
100%	Primary target for the continuation of the trend
138.2%	First extension level beyond 100%, used for strong trends
161.8%	This is the “golden extension” level and is often used as the first major profit-taking point in strong trending markets.
200%	Often used in highly volatile markets or very strong trends
261.8%	Extended target used in exceptionally strong trend scenarios

How to Draw Fibonacci Retracements

1. Identify Peaks and Troughs
   Look for sections of the chart where the price makes a sharp, distinct move upwards or downwards. An impulse move usually starts from a low point (swing low) and reaches a high point (swing high) in bullish scenarios or the opposite in bearish scenarios.
2. Use a Drawing Tool
   The best paper trading platforms offer a Fibonacci drawing tool. To display the key Fibonacci levels automatically, simply click on the movement’s starting point and then on its endpoint.

Noteworthy

You can customize the drawing tool to display additional levels, or alternatively, hide certain Fibonacci levels to prevent your chart from becoming overloaded with information!

Advantages and disadvantages of Fibonacci tools

Let’s break down the advantages and disadvantages of Fibonacci tools.

Pros

• Applicable to all markets. Use Fibonacci tools across stocks, forex, and commodities.

• User friendly. Easily draw them with ProRealTime or other charting softwares

• Spot key levels. Identify potential support and resistance levels where the price might reverse

• Integrates well into trading algorithms. Great for planning trades.

Cons

• Highly subjective. Two traders might draw them differently on the same chart.
• Inconsistent predictions. Sometimes the market blows right past them, which can lead to false signals.
• Chart clutter. Too many “Fib” levels can make charts messy and analysis complicated.
• Retrospective nature. Since Fibonacci tools are based on past price action, they might not always predict future movements, especially in volatile or news-driven markets.

How to Trade with Fibonacci

Fibonacci retracements and extensions are used to trade markets with a clear upward or downward trend. Market pullbacks to retracement levels offer traders opportunities to enter positions in the direction of the trend.

A common technique is to enter at a retracement level and then target an extension level, betting on the continuation of the trend.

Stop-loss orders are typically placed below the Fibonacci retracement level to cut losses automatically if the price falls through this level.

Practical Example: Fibonacci Retracements

Here’s a look at a trading setup on XAUUSD. We used Fibonacci retracement levels alongside supertrend indicator A technical analysis tool that helps identify the direction of a trend and potential entry or exit points. It uses average price data and a volatility factor to create a line on the chart that changes color based on bullish or bearish trends. and the ZigZag pattern A technical analysis tool that highlights significant price movements by filtering out smaller, less meaningful changes. It helps traders visualize trends and reversals by drawing lines between high and low points on a price chart. to shape our decisions.

In this scenario, we entered a long position around $2,440 after expecting a pullback to the 38.2% and 50% retracement zones, which suggested some decent support might be found there. 

These levels gave us a solid entry point, and combining them with the SuperTrend indicator helped confirm that the bullish momentum was likely to continue.

The trade worked out well, as XAUUSD moved higher, allowing us to ride the trend up. We exited around $2,508 once the price broke below the SuperTrend line, signaling a possible reversal or a weakening trend in the short term.

This setup is a good example of how using Fibonacci retracement levels together with other indicators can help identify strong entry points and manage exits.

The main takeaway? Always aim for multiple confirmations to boost trade reliability and manage your risk efficiently.

Practical Example: Fibonacci Extensions

Here’s a solid trading setup on crude oil futures, where we’re using a combination of Fibonacci extensions, the SuperTrend indicator, and a ZigZag pattern to build out strategy.

To start, we applied a Fibonacci extension after noticing a lower high had formed, supported by observations from the ZigZag tool. This, along with a recent lower close, hinted at more bearish movement ahead. We identified a short entry opportunity at $72.40, aiming for the 161.8% Fibonacci extension level at $71.05 as our potential support target.

This setup is a classic example of how a mix of lower highs and other bearish signals can indicate a downtrend continuation, giving you a clear structure for where to enter the trade and what target to aim for.

And it worked out as expected – the price moved down to the 161.8% Fibonacci extension level, hitting our target of $71.05. 

This successful outcome highlights the value of using Fibonacci extensions in combination with other indicators to help confirm a well-rounded trading strategy. It’s a great reminder of how powerful these tools can be when used together.

Fibonacci Retracements and Extensions: Understanding the Differences

Fibonacci retracements are levels that indicate where a current trend may temporarily reverse or pull back. Essentially, these levels show potential spots where the price might retrace a portion of its recent move before continuing in the original direction.

Fibonacci extensions, on the other hand, are used to predict where a current trend might continue beyond its original high or low. These levels are helpful for determining where the trend could extend after surpassing the endpoint of its initial movement.

After an upward move, retracements mark lower price levels than the initial move’s peak, where the price might fall back to before resuming the uptrend. Extensions indicate higher price levels beyond the peak, where the price could potentially rise to.

After a downward move, retracements mark higher price levels than the initial move’s low, where the price might rise back to before continuing the downtrend. Extensions indicate lower price levels below the low, where the price could potentially fall to.

Building a Trading Plan Using Fibonacci

Mastering Fibonacci tools starts with identifying the right swing highs and lows. This can feel like an art, so focus on clear, significant price movements. Use multiple timeframes to confirm key levels. With practice, it becomes second nature.

Combine Fibonacci with other tools like trend lines, support and resistance zones, and moving averages. Candlestick patterns can add even more strength to your setups. This confluence improves your odds.

Stick to essential levels like 38.2%, 50%, and 61.8%. Apply them only to recent, relevant price movements. This keeps your charts clean.

Stay on top of market news and events. Pair Fibonacci with leading indicators to get a more timely read on price action.

And don’t go in based on Fibonacci alone. Look for confirmations like trendline breaks, candlestick patterns, or signals from RSI or MACD. Multiple confirmations lead to more reliable trades.

Interpreting Fibonacci Levels

Fibonacci levels help traders identify potential buying or selling points, often relying on a self-fulfilling prophecy.

In other words, if enough traders use these levels, their buy or sell orders may influence price movements in their favor.

While some traders may strictly buy or sell at Fibonacci levels, others may focus more on the overall market psychology rather than mathematical precision.

Additionally, Fibonacci levels are often combined with other technical indicators such as moving averages or the Relative Strength Index (RSI) to filter and enhance the quality of trading signals.

How to Calculate Fibonacci Retracements

Discovered by the Italian mathematician Leonardo Pisano Fibonacci, the Fibonacci sequence is a series where each number is the sum of the two preceding ones. This sequence starts with 0 and 1 and extends infinitely: 0, 1, 1, 2, 3, 5, 8, 13, 21…

This sequence has unique mathematical properties.

In 1753, the mathematician Robert Simson observed that as the sequence progresses, the ratio between two consecutive numbers tends towards 1.618…

This ratio, known as the “golden ratio,” exhibits unique mathematical properties.

Calculate its inverse (0.618). Calculate its square (0.382). Add these two results, and you get one (1). Take the golden ratio (1.618) and subtract its inverse (0.618), and you get one (1) again!

To calculate Fibonacci Retracements:

1. Identify the Initial Price Movement:

Determine whether the price movement is upward or downward. Calculate the amplitude, which is the difference between the starting and ending points of the price movement.

2. Apply Fibonacci Ratios:

Use predefined percentages derived from the Fibonacci sequence to calculate the retracement levels. Common retracement ratios include 23.6%, 38.2%, 50%, 61.8%, and 78.6%.

Retracements Ratios	Extension Ratios
23,6%, 38,2%, 50%, 61,8%, et 78,6%	100%, 161,8%, 200% et 261,8%

Calculation Formula:

Fibonacci Level = End Price of Initial Movement – (Amplitude × Fibonacci Ratio)

Example of an Upward Trend

Suppose a stock rises from €100 to €200. If it then declines following this initial rise, Fibonacci retracement levels can be used to identify potential support levels where the decline may halt, and traders might consider buying the stock.

These calculations help traders identify where the stock price might find support during a pullback, offering potential entry points for purchasing the stock based on Fibonacci retracement principles:

Retracement level	Calculation	Target buy price
23,6%	200 – 100 x 23,6%	176,40€
38,2%	200 – 100 x 38,2%	161,80€
50%	200 – 100 x 50%	150,00€
61,8%	200 – 100 x 61,8%	138,20€

Example of a Downward Trend

Imagine a stock falling from €100 to €80, a decrease of €20. If this stock begins to rebound after this initial drop, Fibonacci retracement levels can help identify potential resistance levels where the rise may stop, offering traders opportunities to sell the stock.

Retracement Level	Calculation	Target sell price
23,6%	80 + 20 x 23,6%	84,72€
38,2%	80 +20 x 38,2%	87,64€
50%	80 +20 x 50%	90,00€
61,8%	80 +20 x 61,8%	92,36€

Noteworthy

In the best paper trading software, traders can select the initial price movement, and the software will automatically calculate and display Fibonacci retracement and extension levels. This helps traders quickly apply Fibonacci analysis to their strategies.

Fibonacci and Harmonic patterns

Harmonic patterns consist of sequences of bullish and bearish movements framed by Fibonacci retracement and extension levels.

This more complex approach does not suggest traders bet on the overall market trend; instead, it encourages betting on successive trend reversals as part of a fade trading strategy.

Fibonacci levels are particularly useful for identifying potential theoretical support and resistance levels. However, despite their frequent use in programming automated trading algorithms, the predictive power of this technical indicator has yet to be scientifically proven.