Fibonacci Retracement & Extension

<<<<<<< HEAD

Introduction

Fibonacci (Full name: Leonardo Pisano) was a 13th Century Italian mathematician who developed a sequence of mathematical numbers, which described how life is bound by the same mathematical principles. We can use his findings to interpret (in mathematical and charting terms) how the individual ceases to act alone, but acts as a collective, making group decisions.  We'll find out how Fibonacci's (shortened to Fib's) mathematical relationship between his sequences of numbers and crowd mentality plays a critically important role in charting, as well as in nature itself. A more in depth look at Fibonacci numbers can be found on Wikipedia etc… but for now, we as traders only need to know the basics. 

Fibonacci’s numbers are:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.

Each number is simply the sum of the 2 proceeding numbers. It’s remarkable characteristic is the ratio between the numbers - Each number is approximately 1.618 times greater than the proceeding number. This ratio strengthens as we climb higher in numbers. In mathematical learning this is sometimes called retracement studies.  

The key Fib ratios are:
  • 61.8% (the golden Rule) - Divide 1 number by it’s following number. I.e. 13/21 = 0.619 
  • 38.2% - divide 1 number by the number 2 places up. I.e. 55/144 = 0.3819 
  • 23.6% - divide 1 number by the number 3 places up. I.e. 21/89 = 0.23596
The ratio of 61.8 is known as the “Golden Ratio”. It’s found in all walks of life and forms the building blocks in the laws of nature. The golden ratio can be seen throughout the mathematical construction of nature – From architecture, sunflowers, snail’s shells & spiral galaxies. For example the ratio of female bees to male bees in a hive is 1.618 and the difference between the distance from your fingertips to your shoulder and your fingertips to your elbow has the Golden Ratio. This Golden Ratio is also found in finance.

Fibonacci in Technical Analysis

The 1st thing to note is, when using "The Fibonacci Retracement" we are working on the basis that a trend will continue and the reversals are corrective in nature. In other words the retracement's are temporary pull-backs and up-turns within a larger trend. The section on "retracement or reversal – a checklist" will help to identify whether the trend is correcting or reversing. 

Most Charting Software will have the Fibonacci Tool that can be utilised by chartists.  The Fib retracement is created by taking 2 extreme points (usually a peak and trough) on a chart. The extreme points of the Fib are divided vertically by Fib’s ratios – 23.6%, 38.2% and 61.8%. A 50% retracement is also added, because it is an important psychological number. This 50% level was derived from Dow theory and the assertion that a 50% retracement is psychologically on the mind of the collective. These ratios between peak and trough are then drawn horizontally on the chart and are used as stated in the above paragraph to highlight potential trend retracement support and resistance areas.  These areas are useful for trade entry and exit.

WFM - Fibonacci Retracement

The above Whole Foods chart shows how Fib is drawn and used. The Fib is drawn between the trough of a trend (price $34) and it's peak at $66.56. The charting software automatically draws on the ratios at 23.6, 38.2, 50, 61.8 and 100 (Sometimes a 78.1 will also be drawn). See how, as we’ve circled, these ratios offer reversal, support and resistance opportunities. You’ll see that 100 on our Fib scale (right hand side on the chart) signals the start of the drawn line, this is because it will take a 100% price reversal to get back to this price level of $34.

Fibonacci Assumptions and Rules

These ratios don’t always hold, but do offer good technical indication for the trader especially when used with other indicators and price action. Since ALL traders are aware of Fibs and use them WIDELY the ratio levels tend to become self-prophesising, especially is you draw the Fib between obvious peaks and troughs. Fib lines can be drawn from candle body to candle body, or from shadow (or wick) highs and shadow lows, but it’s best not to mix bodies and shadows. They can also be drawn from any peak, trough in any timeframe and be perfectly valid in tech analysis.

However, Fibs work better over the longer term. The shorter the timeframe then the less reliable the data can be as volatility skews support and resistance levels. It’s like any survey – the more data the better the result. Fibs can be used in any chart time-frame, but just bear in mind that it’s better to use multi-time frame analysis focusing on a daily chart over a longer period prior to focusing down. Always use other tech analysis in conjunction with Fibs. Candlesticks, Price action, volume, chart patterns & indicators are always worth confirming 1st.

Trading Fibonacci - A Leading Indicator for Entry

Fibonacci is sometimes thought of as leading indicator particularly if used in a trend. As we have discussed price doesn’t always go up in a trend, as a trend has periods of consolidation. Traders will use Fibonacci Retracement to predict the price downturn/up turn in a period of trend consolidation and then look for entry points if the trend is to continue. The Fib levels of 23.6, 38.2, 50, 61.8 are Alert Zones that traders can anticipate trades from – hence a leading indicator. Keep in mind that these fib levels are not hard reversal, support and resistance levels; but are zones for potential tech analysis.

In our example of EUR/USD below in mid April a strong up trend reached a long consolidation point until late August where the trend continued with higher lows and higher highs. This bottoming of the consolidation occurred on the 50% Fib retracement line where the currency pairing bottomed a couple of times before taking off. I’ve circled the 50% Fibs that traders Many looking to enter at. You’ll also see a 38.2% retracement where bull traders entered, but this rally was very short lived. As a leading indicator The Fib is allowing traders to forecast where a reversal MAY take place and MAY indicate trading opportunities when used with price action and technical analysis. A trend is deemed stronger if the consolidation hits the 38.2% retracement then rebounds to continue the trend.

EUR/USD - Fibonacci as a Leading Indicator

Fibonacci Trading Confirmation

Combining Fib retracement with other tech analysis is a must. In our EUR/USD chart above we have a stochastic oscillator. Notice how an oversold 20 crossover line, a stochastic / 5 period MA cross over and 50% retracement align on the 24th/25th Aug. There’s also a spinning top indicating a possible reversal (See Price action Module 5). Before trading, traders like to get confirmation.  

Confirmation in the way of:
  • A double confirmation of Fib support levels
  • Candlestick patterns (see price action module 5)
  • Increased volume on trend continuation
  • Moving averages support & resistance levels met
  • Trend Lines Met
  • Previous Resistance becomes support and vice-versa (below chart)
Looking back at previous support and resistance levels is a good idea to get confirmation that the Fib retracement is holding.  These historical levels can be previous Fib extension levels, or other levels set by moving averages, significant round numbers, etc...  In the chart below, look how a previous resistance level now become support and this coincides with a 50% retracement.  This level is highlighted with a blue line.  This 50% Fib Retrace, is not only support from a previous resistance level, it also holds 3 times.  This is good trading confirmation. 

USD/CHF - Fibonacci Extension now becomes Support

Trading Fibonacci - Setting Profit Targets with the Extension

Fibonacci can be used to calculate profit-taking levels. We’ll use the same Fibonacci set-up as above on the EUR/USD and highlight the whole profit set-up in a new chart of EUR/USD below. The Fib is kept in the same place, so we have an up trend between June and Aug with a retracement to the end of Aug. To calculate profit targets we can use Fibonacci Extensions. The most common of which are 0.382 and 0.618.

We use The ABCD Fibonacci pattern to establish our trading strategy. The start point of our Fib is labelled A, while the end of the Fib is labelled B – That’s the easy bit. Now it gets a wee bit harder as we need to establish our trade entry point. If we have established we’re in a trend and we’ve recognized the down turn is a consolidation period prior to the trend continuing then we need to find our entry point (The section Retracement or Reversal – a Checklist, in this module should help here).

In or example, using Fib retracement, the EUR/USD retraces back to 50% on 24th Aug with a stochastic oversold signal. We could have entered here, or we could have entered on the 31st Aug or 10th Sep. At both these later dates the 50% retracement has been confirmed, indicating support. In our example entry was 31st of Aug as a double bounce on support is good confirmation that support will hold (volumes can help here where buying pressure will increase on support – not shown.  SMA will also help confirmation). This Long (BUY) entry point is our C point. Be aware of support and resistance levels and trading channels, as your profit targets could be affected be these.

EUR/USD - Fibonacci Extension to Set Profit Targets

Our profit target needs to be set now. This is where Fib Extensions come into play. Some software applies these automatically, but others you will need to edit yourself. Usually you can edit the properties of Fibonacci to achieve this. You’ll see on our example I’ve had to edit the Fib with a -38.2, -50 and –61.8 to get the extensions – these are our 0.382, 0.50 and 0.618 extensions. You can calculate the Fib extension yourself by the following formula where A = the 100% retracement and B is the 0% retracement.

Up tend: D = B + {(B-A) x Fib Extension}              Downtrend: D = B – {(A-B) x Fib Extension}

Important: Some traders will calculate from A meaning our 0.618 extension becomes 1.618 – just be aware of this when looking at other resources.

In our EUR/USD example our profit target at D occur on 14th Oct. If our entry point is 50% retracement, our target should be 50% extension (or 1.5 in some software). The same applies for 38.2% and 61.8% etc… We could have reduced our expectations here and taken profit at the 38.2 extension, which would have also been profitable. It’s almost like a self-fulfilling event, as most technical traders will be looking at the same stand out Fibonacci to profit. The 50% extension was hit on the button, prior to profit taking. Notice how the FX pairing hits the 61.8% extension exactly prior to a reverse - This has now become an important resistance level as can be seen to the far right of our chart.  

Example Fibonacci Trade

Fibonacci Simple Trend Trade (Using above EUR/USD chart)
  • Draw Fib and get Fib retracement confirmation (see above)
  • Confirmation set at point (C)
  • Profit Target (D) is 50% (or 1.50) extension line
  • Stop/Loss placed either at next Fib level below entry point (in this case 61.8%).  This allows the trade to breathe, but may be a little to much for some.  It all depends on your risk threshold.  A longer term trader may place the stop way back at the 100% retracement, while a day trader may place the stop under the last candle bottom
  • Risk/Reward.  If target is D (1.41), entry (C) is 1.26 and you lace a stop at 1.245 (under 61.8%) your risk reward is profit (D)-(C) = 0.15 / potential loss (C)-Stop = 0.015 = 10:1.  
  • Set trailing stop under trend line, moving averages of below the last candle low.
Fibonacci Extensions - Future Support and Resistance

As indicated in the above paragraph, Fibonacci extensions can form important support and resistance levels for future price action. As seen in the above EUR/USD currency pairing chart the November high at extension level 61.8% now becomes resistance for future price moves in January 2011. Support and resistance levels can be seen along the length of the extension as we go ever higher. For instance the 1.382% (or 2.138%), 161.8% (or 261.8%), etc.. may also become an important support/resistance level in the future too.

To Sum Up

The value of Fibonacci's numbers is clear to see in nature as well as in finance and should be an important part of your trading strategy.  As we've seen Fibonacci is a trading tool used by many Chartists to anticipate trade entry points as well as setting profit targets and stop/loss positions.  However, it's not an all-in-one trading solution and should always be utilised with other technical analysis.  

There's a strong relationship between Fibonacci, human nature and crowd mentality.  One theory that we'll go on to talk about is The Elliot Wave, which used Fibonacci as it's basis.  This theory and the psychology of trading need to be looked at at this point.

Some points to note are:
    • Fibonacci ratio retracements don’t always happen, but play around with Fibs to satisfy yourself of it’s worth to your own trading strategy.  
    • Be aware of support and resistance levels and trading channels, as your profit targets will be affected be these too.
    • It’s best to trade in the direction of the trend. 
    • Use Multi-timeframe analysis, other chart patterns, price action and other tech analysis for confirmation of trend, entry and exit.
Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.



=======

Introduction

Fibonacci (Full name: Leonardo Pisano) was a 13th Century Italian mathematician who developed a sequence of mathematical numbers, which described how life is bound by the same mathematical principles. We can use his findings to interpret (in mathematical and charting terms) how the individual ceases to act alone, but acts as a collective, making group decisions.  We'll find out how Fibonacci's (shortened to Fib's) mathematical relationship between his sequences of numbers and crowd mentality plays a critically important role in charting, as well as in nature itself. A more in depth look at Fibonacci numbers can be found on Wikipedia etc… but for now, we as traders only need to know the basics. 

Fibonacci’s numbers are:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.

Each number is simply the sum of the 2 proceeding numbers. It’s remarkable characteristic is the ratio between the numbers - Each number is approximately 1.618 times greater than the proceeding number. This ratio strengthens as we climb higher in numbers. In mathematical learning this is sometimes called retracement studies.  

The key Fib ratios are:
  • 61.8% (the golden Rule) - Divide 1 number by it’s following number. I.e. 13/21 = 0.619 
  • 38.2% - divide 1 number by the number 2 places up. I.e. 55/144 = 0.3819 
  • 23.6% - divide 1 number by the number 3 places up. I.e. 21/89 = 0.23596
The ratio of 61.8 is known as the “Golden Ratio”. It’s found in all walks of life and forms the building blocks in the laws of nature. The golden ratio can be seen throughout the mathematical construction of nature – From architecture, sunflowers, snail’s shells & spiral galaxies. For example the ratio of female bees to male bees in a hive is 1.618 and the difference between the distance from your fingertips to your shoulder and your fingertips to your elbow has the Golden Ratio. This Golden Ratio is also found in finance.

Fibonacci in Technical Analysis

The 1st thing to note is, when using "The Fibonacci Retracement" we are working on the basis that a trend will continue and the reversals are corrective in nature. In other words the retracement's are temporary pull-backs and up-turns within a larger trend. The section on "retracement or reversal – a checklist" will help to identify whether the trend is correcting or reversing. 

Most Charting Software will have the Fibonacci Tool that can be utilised by chartists.  The Fib retracement is created by taking 2 extreme points (usually a peak and trough) on a chart. The extreme points of the Fib are divided vertically by Fib’s ratios – 23.6%, 38.2% and 61.8%. A 50% retracement is also added, because it is an important psychological number. This 50% level was derived from Dow theory and the assertion that a 50% retracement is psychologically on the mind of the collective. These ratios between peak and trough are then drawn horizontally on the chart and are used as stated in the above paragraph to highlight potential trend retracement support and resistance areas.  These areas are useful for trade entry and exit.

WFM - Fibonacci Retracement

The above Whole Foods chart shows how Fib is drawn and used. The Fib is drawn between the trough of a trend (price $34) and it's peak at $66.56. The charting software automatically draws on the ratios at 23.6, 38.2, 50, 61.8 and 100 (Sometimes a 78.1 will also be drawn). See how, as we’ve circled, these ratios offer reversal, support and resistance opportunities. You’ll see that 100 on our Fib scale (right hand side on the chart) signals the start of the drawn line, this is because it will take a 100% price reversal to get back to this price level of $34.

Fibonacci Assumptions and Rules

These ratios don’t always hold, but do offer good technical indication for the trader especially when used with other indicators and price action. Since ALL traders are aware of Fibs and use them WIDELY the ratio levels tend to become self-prophesising, especially is you draw the Fib between obvious peaks and troughs. Fib lines can be drawn from candle body to candle body, or from shadow (or wick) highs and shadow lows, but it’s best not to mix bodies and shadows. They can also be drawn from any peak, trough in any timeframe and be perfectly valid in tech analysis.

However, Fibs work better over the longer term. The shorter the timeframe then the less reliable the data can be as volatility skews support and resistance levels. It’s like any survey – the more data the better the result. Fibs can be used in any chart time-frame, but just bear in mind that it’s better to use multi-time frame analysis focusing on a daily chart over a longer period prior to focusing down. Always use other tech analysis in conjunction with Fibs. Candlesticks, Price action, volume, chart patterns & indicators are always worth confirming 1st.

Trading Fibonacci - A Leading Indicator for Entry

Fibonacci is sometimes thought of as leading indicator particularly if used in a trend. As we have discussed price doesn’t always go up in a trend, as a trend has periods of consolidation. Traders will use Fibonacci Retracement to predict the price downturn/up turn in a period of trend consolidation and then look for entry points if the trend is to continue. The Fib levels of 23.6, 38.2, 50, 61.8 are Alert Zones that traders can anticipate trades from – hence a leading indicator. Keep in mind that these fib levels are not hard reversal, support and resistance levels; but are zones for potential tech analysis.

In our example of EUR/USD below in mid April a strong up trend reached a long consolidation point until late August where the trend continued with higher lows and higher highs. This bottoming of the consolidation occurred on the 50% Fib retracement line where the currency pairing bottomed a couple of times before taking off. I’ve circled the 50% Fibs that traders Many looking to enter at. You’ll also see a 38.2% retracement where bull traders entered, but this rally was very short lived. As a leading indicator The Fib is allowing traders to forecast where a reversal MAY take place and MAY indicate trading opportunities when used with price action and technical analysis. A trend is deemed stronger if the consolidation hits the 38.2% retracement then rebounds to continue the trend.

EUR/USD - Fibonacci as a Leading Indicator

Fibonacci Trading Confirmation

Combining Fib retracement with other tech analysis is a must. In our EUR/USD chart above we have a stochastic oscillator. Notice how an oversold 20 crossover line, a stochastic / 5 period MA cross over and 50% retracement align on the 24th/25th Aug. There’s also a spinning top indicating a possible reversal (See Price action Module 5). Before trading, traders like to get confirmation.  

Confirmation in the way of:
  • A double confirmation of Fib support levels
  • Candlestick patterns (see price action module 5)
  • Increased volume on trend continuation
  • Moving averages support & resistance levels met
  • Trend Lines Met
  • Previous Resistance becomes support and vice-versa (below chart)
Looking back at previous support and resistance levels is a good idea to get confirmation that the Fib retracement is holding.  These historical levels can be previous Fib extension levels, or other levels set by moving averages, significant round numbers, etc...  In the chart below, look how a previous resistance level now become support and this coincides with a 50% retracement.  This level is highlighted with a blue line.  This 50% Fib Retrace, is not only support from a previous resistance level, it also holds 3 times.  This is good trading confirmation. 

USD/CHF - Fibonacci Extension now becomes Support

Trading Fibonacci - Setting Profit Targets with the Extension

Fibonacci can be used to calculate profit-taking levels. We’ll use the same Fibonacci set-up as above on the EUR/USD and highlight the whole profit set-up in a new chart of EUR/USD below. The Fib is kept in the same place, so we have an up trend between June and Aug with a retracement to the end of Aug. To calculate profit targets we can use Fibonacci Extensions. The most common of which are 0.382 and 0.618.

We use The ABCD Fibonacci pattern to establish our trading strategy. The start point of our Fib is labelled A, while the end of the Fib is labelled B – That’s the easy bit. Now it gets a wee bit harder as we need to establish our trade entry point. If we have established we’re in a trend and we’ve recognized the down turn is a consolidation period prior to the trend continuing then we need to find our entry point (The section Retracement or Reversal – a Checklist, in this module should help here).

In or example, using Fib retracement, the EUR/USD retraces back to 50% on 24th Aug with a stochastic oversold signal. We could have entered here, or we could have entered on the 31st Aug or 10th Sep. At both these later dates the 50% retracement has been confirmed, indicating support. In our example entry was 31st of Aug as a double bounce on support is good confirmation that support will hold (volumes can help here where buying pressure will increase on support – not shown.  SMA will also help confirmation). This Long (BUY) entry point is our C point. Be aware of support and resistance levels and trading channels, as your profit targets could be affected be these.

EUR/USD - Fibonacci Extension to Set Profit Targets

Our profit target needs to be set now. This is where Fib Extensions come into play. Some software applies these automatically, but others you will need to edit yourself. Usually you can edit the properties of Fibonacci to achieve this. You’ll see on our example I’ve had to edit the Fib with a -38.2, -50 and –61.8 to get the extensions – these are our 0.382, 0.50 and 0.618 extensions. You can calculate the Fib extension yourself by the following formula where A = the 100% retracement and B is the 0% retracement.

Up tend: D = B + {(B-A) x Fib Extension}              Downtrend: D = B – {(A-B) x Fib Extension}

Important: Some traders will calculate from A meaning our 0.618 extension becomes 1.618 – just be aware of this when looking at other resources.

In our EUR/USD example our profit target at D occur on 14th Oct. If our entry point is 50% retracement, our target should be 50% extension (or 1.5 in some software). The same applies for 38.2% and 61.8% etc… We could have reduced our expectations here and taken profit at the 38.2 extension, which would have also been profitable. It’s almost like a self-fulfilling event, as most technical traders will be looking at the same stand out Fibonacci to profit. The 50% extension was hit on the button, prior to profit taking. Notice how the FX pairing hits the 61.8% extension exactly prior to a reverse - This has now become an important resistance level as can be seen to the far right of our chart.  

Example Fibonacci Trade

Fibonacci Simple Trend Trade (Using above EUR/USD chart)
  • Draw Fib and get Fib retracement confirmation (see above)
  • Confirmation set at point (C)
  • Profit Target (D) is 50% (or 1.50) extension line
  • Stop/Loss placed either at next Fib level below entry point (in this case 61.8%).  This allows the trade to breathe, but may be a little to much for some.  It all depends on your risk threshold.  A longer term trader may place the stop way back at the 100% retracement, while a day trader may place the stop under the last candle bottom
  • Risk/Reward.  If target is D (1.41), entry (C) is 1.26 and you lace a stop at 1.245 (under 61.8%) your risk reward is profit (D)-(C) = 0.15 / potential loss (C)-Stop = 0.015 = 10:1.  
  • Set trailing stop under trend line, moving averages of below the last candle low.
Fibonacci Extensions - Future Support and Resistance

As indicated in the above paragraph, Fibonacci extensions can form important support and resistance levels for future price action. As seen in the above EUR/USD currency pairing chart the November high at extension level 61.8% now becomes resistance for future price moves in January 2011. Support and resistance levels can be seen along the length of the extension as we go ever higher. For instance the 1.382% (or 2.138%), 161.8% (or 261.8%), etc.. may also become an important support/resistance level in the future too.

To Sum Up

The value of Fibonacci's numbers is clear to see in nature as well as in finance and should be an important part of your trading strategy.  As we've seen Fibonacci is a trading tool used by many Chartists to anticipate trade entry points as well as setting profit targets and stop/loss positions.  However, it's not an all-in-one trading solution and should always be utilised with other technical analysis.  

There's a strong relationship between Fibonacci, human nature and crowd mentality.  One theory that we'll go on to talk about is The Elliot Wave, which used Fibonacci as it's basis.  This theory and the psychology of trading need to be looked at at this point.

Some points to note are:
    • Fibonacci ratio retracements don’t always happen, but play around with Fibs to satisfy yourself of it’s worth to your own trading strategy.  
    • Be aware of support and resistance levels and trading channels, as your profit targets will be affected be these too.
    • It’s best to trade in the direction of the trend. 
    • Use Multi-timeframe analysis, other chart patterns, price action and other tech analysis for confirmation of trend, entry and exit.
Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.



>>>>>>> c0fd65f8ac5b5830dc3df1d307fcababd602b3a9
Comments