The Fibonacci extension tool, available on most trading platforms, can help establish profit targets on trend trades or alert a trader to where potential trend reversal areas could develop. Throughout nature there is a repeating pattern, based on a series of “Fibonacci numbers” which Leonardo Pisano Bogollo introduced to the West. The number series is based on the Golden Ratio, a number found in galaxy formations, plant growth and man-made structures. These “Fibonacci levels” are also found in financial markets, and can help us determine where the market is going.
Fibonacci Numbers and Fibonacci Extension Levels
When the price of an asset trends higher (in an uptrend, the up waves are called impulse waves and the pullbacks are corrective waves) following a pullback, that impulse wave higher typically has a mathematical relationship to the impulse wave that preceded it. This relationship is based on the “Golden Ratio” and a series of “Fibonacci Numbers” which help define the numerical relationship of one thing to another. The same principle applies to downtrends. A downward impulse wave typically has a mathematical relationship to the impulse wave prior.
As a quick introduction, the following are Fibonacci numbers:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377….
The next number in the sequence is the sum of the prior two numbers before it. The third number is 1 because the prior two numbers are 0 and 1. The five is a result of adding 2 and 3. 89 is the result of adding 34 and 55. The number sequence continues indefinitely.
The “Golden Ratio” is derived from this sequence. As the sequence progresses, if a number is divided by the prior number it produces a ratio. 3/2 is 1.5, 13/8 is 1.625. As the numbers progress the relationship (ratio) reaches the Golden Ratio, 1.618. Since the number shows the relationship between an infinite amount of numbers (once the sequence gets going), it also tends to appear throughout nature.
Common Fibonacci Extension levels are 161.8%, 261.8% and 423.6%. As the sequence grows, if you divide a number by the prior number it gravitates toward 161.8%. It doesn’t at the start of the sequence, but as the numbers get bigger, this ratio appears. If you divide a number (once the sequence is well underway) by the number two places before it, the result gravitates toward 261.8%. Dividing a number by the number three places before it results in 423.6%. There are also other Extension levels discussed in the next section.
Fibonacci extension levels (also called Fibonacci expansion levels) are most accurate on popular and highly liquid currency pairs, stocks and futures contracts. A low volume market is more swayed by individuals (and not a large group of traders) and therefore may have erratic movements that don’t align with the Fibonacci extension levels.
Using the Fibonacci Extension Tool
There is some interesting history behind Fibonacci numbers, and trading tools utilizing them, but ultimately we don’t need to know this history to trade. If you are interested in the history and further application of Fibonacci tools, one of the premier books on the subject is now available for free download: Elliott Wave Principle eBook.
The Fibonacci Extension tool is applied to one wave of a price move, which in turn helps to predict where future waves in that trend will go to, and possibly reverse.
I utilize the following Fibonacci extension levels on my chart:
61.8%, 100%, 138.2%, 161.8%, 200%, 238.2%, 261.8%. These Fibonacci Expansion levels are attained by finding relationships between the numbers in the Fibonacci sequence, discussed above, through various calculations.
To use the tool, you’ll need to apply it to you chart; how to do this will vary by trading platform. In MetaTrader4, go to Insert, then Fibonacci and select Expansion. To apply the tool to an uptrend, click at the bottom of a price wave, and drag the tool to the top of the price wave. You’ll notice the Fibonacci extension has two lines. The first is the one you just drew from the low to the high. The next line is drawn (dragged) to the low of the current retracement (or where you expect a retracement could go….for anticipating retracement levels, you can utilize the Fibonacci retracement tool).
Figure 1 shows a Fibonacci extension tool applied to a price wave in an uptrend. The tool starts at the bottom of an up wave and connects to the top of the up wave; the second line of the tool reaches down to the low of the retracement following the wave higher. The tool then helps predict where the next up wave is likely to go–in this case to the 100% level, circled on the chart.
Figure 1. EUR/USD 4-Hour Chart with Fibonacci Extension Tool
Double click on the tool to move it or edit it. Drag the dots to line them up with the relevant highs and lows in price. You can also right-click on the indicator to bring up the properties of the tool. From there you may need to add some of the Fibonacci extension levels mentioned prior, since they may not all be included by default.
Once you have drawn the tool once, you’re going to need it several more times throughout the day. Instead of going through the menu again, in MetaTrader you can simply click on the tool to select it, then hold down the Ctrl key and left click on the tool. This will duplicate the tool, then you can drag the duplicate to where you need it and adjust it the relevant highs and lows of the new price wave(s).
The Fibonacci Extension tool can be applied to any market, and any time frame from tick charts to weekly charts and beyond.
Finding Potential Reversal and Target Areas with the Fibonacci Extension Tool
Figure 1 above shows the Fibonacci extension tool applied to an up wave. When the price continues higher it stops very close one of the extension point 100, and then reverses.
The level the price stops at will vary depending on the strength of the trend. Most often we see the price pause or reverse at 61.8, 100, or 161.8. Once the reversal occurs we can then draw another Fibonacci extension, but we will keep the old one(s) on the chart as well, since down the road there are additional levels which can still be used such as the 200, 238.2, 261.8 and 300.
Figure 2 shows two Fibonacci extension levels applied to consecutive waves in an uptrend.
Figure 2. EUR/USD Daily Chart with Fibonacci Extensions
Once the price starts to move higher, we can draw a second Fibonacci extension, as shown in Figure 2. Even with using two tools at the same time, the chart can start to get cluttered. Therefore, we look for areas where the most Fibonacci levels are clustered. Since we are assuming the uptrend will continue, we look for these Fibonacci clusters above the former high.
I have circled a second area in grey, which is where we have three Fibonacci levels in close proximity to one another. The price stalls in this area and then pulls back.
We can continue to repeat this process, drawing a new Fibonacci expansion on each new price swing. When the price reverses we draw the expansion tool to forecast the emerging downtrend.
Figure 3. EUR/USD Daily Chart with Fibonacci Extension in Downtrend
Figure 3 shows the expansion tool applied to a downtrend. As the downtrend progresses it reaches more and more of the extension levels, all which could be potential profit target areas for short trades.
Fibonacci Extension Tool Considerations
The tool can be applied to any time frame, from tick charts all up to daily or monthly charts; no matter what timeframe you trade on the application of the tool is the same.
Use the Fibonacci extensions tool to provide profit targets on trending trades. Typically I will use the 61.8 or 100 level, and if the market is moving very strongly I may adjust the target to the 161.8 level. All the levels mark areas where the price could quite possibly stall or reverse, so exit (take profit) slightly before the price reaches the actual extension level.
Fibonacci extension levels indicate potential profit target areas. The price could reverse at these levels as well, but we can’t know that in advance. Therefore, using Fibonacci extension levels for profit targets is preferred to using extension levels in an attempt to predict where a trend will reverse. Trade in the direction of the trend, using extensions as a guide, and forget about trying to predict reversals in advance.
Sometimes the price will charge through the 61.8 level and proceed to the 100 level. Other times it will move right to 161.8 level before stalling. Each level marks an area of potential support/resistance. If the price moves aggressively through a Fibonacci extension level, then it is likely heading toward the next one (in theory).
Apply the Fibonacci extension tool to multiple waves, and even different time frames to be aware of different levels which may affect the price of an asset.
Once you’ve draw three Fibonacci extensions, you can start to delete the first ones you drew, since your chart will become too cluttered and you’ll have levels all over the place which is of little value. Also, if your chart is too cluttered, you can delete any old Fibonacci drawings where the price has moved past the 161.8 level.
How I Use Fibonacci Extension Levels
I rarely use Fibonacci extension levels in short-term trading. When I am day trading (see how I do it here) I am usually in and out of trades quite quickly, using a 2:1 or 3:1 reward:risk ratio. So using a Fib. expansion level isn’t really going to help since my targets are fairly automatic. When swing trading, I typically place profit targets on the opposite side of the price structure the market is moving in (for example, just below resistance if long, or just above support if short). With swing trading and day trading, I also look at the surrounding price action and base my profit targets on the most common tendencies in the price.
I do use the Fibonacci expansion levels in my investing (longer-term trading). My investing strategy is to buy stocks and commodities at very depressed prices. Once the asset has a major move higher, that up wave can be used to project the next wave…and the next. I typically assume that the next wave will go to the 100 or 161 level, but I do look to history to tell me if the particular asset shows this tendency. If an asset shows a tendency to move to a different level, I will use that. Once the price reaches this level, it often experiences a big pullback before having another move to the upside (uptrends typically have at least 3 big waves to the upside). For this third up wave, I typically assume it will be the same size as the first wave higher (or about 0.618 of the second wave up).
In other words, I am using a few common tendencies to construct approximately how far a whole trend could move, based on the first wave higher . I fine-tune the projection as the price creates more waves. I don’t actually expect my projection to be exactly where the whole trend will reverse, but my long-term projection/profit target does give me a ball-park estimate of where I will be exiting the trade, which in turns gives me an idea of the type of reward:risk I am looking at on my investment. I only take investment opportunities with high reward:risk ratios (100% or more on capital).
Using Fibonacci extensions isn’t required to trade successfully. Use the tool if it helps you; if you find it of little value, never look at it again. Be sure to practice with it and test it out before incorporating it into your trading plan or using real capital.
Final Word on Using Fibonacci Extensions
Use the Fibonacci Expansion tool in all markets and on all time frames. It is a trend following tool, and helps isolate potential profit targets for trades. It is also used to spot areas where the price could reverse, although using it to predict reversals isn’t encouraged. The price may not stop exactly at a Fibonacci level, rather the Fibonacci levels are just a guide. We also don’t know if the price will reverse off a Fibonacci level, just stall or only pullback slightly. Sometimes the price will completely disregard Fibonacci levels, often when major news occurs.
Don’t try to force a tool to work if it isn’t working for you; you don’t need to use Fibonacci extension levels to trade successfully. I don’t typically use the Fibonacci expansion tool in my short-term trading, but I do use it in a rather complex way for my investing strategy. In all cases though, I don’t rely on it exclusively or put much weight on it; it is just a tool.
Also, be sure to check out how to use Fibonacci Retracements: Use Fibonacci Retracements to Find Trading Entry Points
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