How to Use Fibonacci Retracement and Extension Levels in Trading

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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.

Key Takeaways

Fibonacci levels are key price points calculated from an initial upward or downward price movement.

Fibonacci extensions are price levels indicating where the market is likely to extend its initial movement. The most popular Fibonacci extension levels are 100%, 161.8%, and 200%.

Fibonacci levels are used by many  traders and trading algorithms, but these support and resistance levels are far from foolproof. To date, no study has proven their effectiveness.

WARNING

Trading exposes you to the risk of losing more than your initial investment and incurring financial liability. Trading is suitable only for well-informed, sophisticated clients able to understand how the products being traded work and having the financial ability to bear the aforementioned risk.

Transactions involving foreign exchange instruments (FOREX) and contracts for difference (CFD) are highly speculative and extremely complex. As such, they are subject to a high level of risk due to leverage. Please keep in mind that CDF trading is banned in the US.

Information published on the NewTrading.io website is for educational purposes only and should not be construed as offering investment advice or as an enticement to trade financial instruments.

Understanding Fibonacci Levels

Fibonacci levels are key price points on a trader’s chart, marked by horizontal lines that are calculated based on an initial price movement, either upward or downward.

These levels serve as theoretical support or resistance points, providing traders with crucial reference points for buying or selling decisions. Derived from the Fibonacci sequence, these levels help predict potential reversals in the price movement.

Fibonacci Retracements

Fibonacci retracements indicate points where the price of a security may temporarily stop or reverse following a significant price movement. Retracements provide a way to gauge how deeply a market might pull back against a trend.

  • 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 LevelCommon 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

Example of a Retracement during an Uptrend:

ProRealTime Web Chart of the NASDAQ Composite Index. Following the initial upward impulse, prices declined to test the 61.80% Fibonacci retracement level before moving higher again. This level served as support

Fibonacci Extensions

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.

  • 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 LevelCommon Usage
100%Primary target for the continuation of the trend
138.2%First extension level beyond 100%, used for strong trends
161.8%Major extension level used as a potential profit-taking point
200%Often used in highly volatile markets or very strong trends
261.8%Extended target used in exceptionally strong trend scenarios

Example of an extension during an uptrend:

ProRealTime Web chart of the NASDAQ Composite index. Following the initial upward momentum, prices advance to the 100% Fibonacci extension level at 14,357 points, which repeatedly acts as a resistance.

Advantages and disadvantages of Fibonacci tools

Pros
  • Applicable to all markets

  • Identifies theoretical support and resistance levels

  • Useful in the development of trading algorithms and strategies

Cons
  • The ability of Fibonacci levels to predict future price movements hasn’t been conclusively demonstrated.

  • Initial movement selection is subjective

  • The multiplication of support and resistance levels might cause confusion

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.

Drawing 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!

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.

Trading 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.

ProRealTime Web Chart of LVMH Stock. Following the initial upward surge, the prices pull back. Here, the 61.8% retracement level provides a potential buying zone (shown in green). Traders can consider buying at this retracement level and place a stop-loss order below this key level.

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…

Fibonacci-Suite

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 RatiosExtension 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 levelCalculationTarget 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 LevelCalculationTarget 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.

author
Maxime Parra

Maxime holds two master’s degrees from the SKEMA Business School and FFBC: a Master of Management and a Master of International Financial Analysis. As founder and editor-in-chief of NewTrading.fr, he writes daily about financial trading.

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