What are Fibonacci extensions?
Fibonacci extensions are a tool that traders can use to set profit targets or estimate how far a price can travel after a pullback / retracement ends. Extension levels are also possible areas where the price can reverse.
The spreads are drawn on a graph, marking the price levels of possible importance. These levels are based on the Fibonacci ratios (as percentages) and the size of the price movement to which the indicator is applied.
- Common Fibonacci extension levels are 61.8%, 100%, 161.8%, 200%, and 261.8%.
- Fibonacci extensions show how far the next price wave could move after a pullback.
- Fibonacci ratios are common in everyday life, seen in galaxy formations, architecture, and how some plants grow. Therefore, some traders believe that these common ratios may also matter in financial markets.
- Extension levels indicate possible areas of importance, but should not be relied upon exclusively.
The formula for Fibonacci extensions
Fibonacci extensions have no formula. When the indicator is applied to a chart, the trader chooses three points. Once all three points are chosen, the lines are drawn at percentages of that move. The first point chosen is the start of a move, the second point is the end of a move, and the third point is the end of the pullback against that move. The extensions then help project where the price might go next.
How to calculate Fibonacci retracement levels
- Multiply the difference between points one and two by any of the desired proportions, such as 1.618 or 0.618. This gives you a dollar amount.
- If you project a higher price movement, add the previous dollar amount to the price in point three. If you project a lower price movement, subtract the dollar amount in step one from the price in step three.
For example, if the price moves from $ 10 to $ 20, back to $ 15, $ 10 could be point one, $ 20 point two, and $ 15 point three. Fibonacci levels will then project above $ 15, providing upside levels of where price could go next. If instead the price falls, the indicator should be redrawn to match the lower price at point three.
If the price rises from $ 10 to $ 20, and these two price levels are points one and two used in the indicator, then the 61.8% level will be $ 6.18 (0.618 x $ 10) above the chosen price for point three. In this case, point three is $ 15, so the 61.8% spread level is $ 21.18 ($ 15 + $ 6.18). The 100% level is $ 10 above point three for a $ 25 extension level ((1.0 x $ 10) + 15).
The ratios themselves are based on something called the golden ratio.
To learn about this proportion, start a sequence of numbers with zero and one, and then add the previous two numbers to end up with a string of numbers like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987 …
Fibonacci extension levels are derived from this string of numbers. Excluding the first few numbers, as the sequence progresses, if you divide a number by the previous number, you get a ratio close to 1.618, such as dividing 233 by 144. Divide a number by two places to 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 numbers, but they are useful as they project a similar movement (or a multiple) to what just happened on the price chart.
What do the Fibonacci extensions tell you?
Fibonacci extensions are a way to set price targets or find projected areas of support or resistance when price moves into an area where other methods of finding support or resistance are not applicable or obvious.
If the price moves through one extension level, it can continue to move to the next. That being said, Fibonacci extensions are areas of possible interest. Price may not stop and / or pull back right at the level, but the area around it may be important. For example, the price may move a bit past the 1.618 level, or rise a bit before changing direction.
If a trader is long on a stock and a new high occurs, the trader can use Fibonacci extension levels to get an idea of where the stock can go. The same is true for a trader who is short. Fibonacci extension levels can be calculated to give the trader insights into the location of the profit target. The trader then has the option to decide whether to hedge the position at that level.
Fibonacci extensions can be used for any period of time or in any market. Typically, Fibonacci level clusters indicate a price area that will be significant to the action and also to traders in their decision making. Since extension levels can be drawn in different price waves over time, when multiple levels of these different waves converge on one price, that could be a very important area.
The difference between Fibonacci extensions and Fibonacci retracements
While extensions show where the price will go after a pullback, Fibonacci retracement levels indicate how deep a pullback could be. In other words, Fibonacci retracements measure retracements within a trend, while Fibonacci extensions measure impulse waves in the direction of the trend.
Limitations of using Fibonacci extensions
Fibonacci extensions are not meant to be the sole determining factor in whether to buy or sell a stock. It is recommended that investors use extensions in conjunction with other indicators or patterns when seeking to determine one or more price targets. Candlestick patterns and price action are especially informative when it comes to determining whether a stock is likely to reverse at the target price.
There is no guarantee that the price will reach or retrace at a certain extension level. Even if it does, it is not apparent before a trade is made which Fibonacci extension level will be important. The price could move through many of the levels with ease or not reach any of them.