The Fibonacci sequence is frequently found throughout the natural world. From the profiles of seashells and hurricanes to its role in fractal geometry, examples of the golden ratio are all around us.
Derivatives of the Fibonacci sequence are regularly applied to the financial markets. Fibonacci extensions, retracements, and expansions are tools that active futures traders often use to place pricing fluctuations into context. They are readily adaptable to almost any trading plan and useful in trade selection or position management.
Among the various Fibonacci tools, extensions offer active traders significant utility. When used in conjunction with prevailing market fundamentals and additional technicals, they may serve as an invaluable part of almost any comprehensive trading strategy.
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Calculating Fibonacci Extensions
The methodology behind calculating Fibonacci extensions dictates their ultimate purpose: identify areas of potential support and resistance.
The actual math involved in deriving extension levels is not overly complex, but it’s certainly tedious. Fortunately, the vast majority of software trading platforms have streamlined the process to just a few clicks of the mouse.
In order to calculate an extension, you need three specific price points:
- Relevant swing high: Serves as the periodic high value.
- Relevant swing low: Serves as the periodic low value.
- Desired Fibonacci retracement level: Extensions are regularly based upon the 38.2%, 50%, or 61.8% retracement levels falling between the swing high and swing low.
Depending upon your trading software’s functionality, a simple click on each value in accordance with the prevailing trend will create a completed extension. For instance, to create Fibonacci extensions in markets that are trending higher:
- Click on the swing low
- Click on the swing high
- Click on the desired retracement level
The result will appear as a chart overlay of the extension levels, commonly 138.2%, 150%, and 161.8%. The reversed process (swing high to swing low) is used for calculating extensions in a downtrend.
Unfortunately, the selection of pertinent swing highs and swing lows is a matter of interpretation. Every market dynamic is unique, so becoming adept at using Fibonacci extensions is a product of both experience and practice.
Applications
The versatility of Fibonacci tools makes them attractive to novice and veteran traders alike. Trend and reversal identification, as well as order placement, are some of the active trading applications in which Fibbies shine.
Here are some of the common uses of Fibonacci extensions:
- Identification of support and resistance: As mentioned earlier, this is the primary function of extensions. By gaining insight into where a market is likely to stall out or reverse, traders can adjust their strategies accordingly.
- Market entry: Opening a counter-trend position from an extension level is a common practice in reversal trading.
- Market exit: Setting profit targets at defined levels can be an efficient way of limiting risk while maximizing reward. Traders may also use extensions as supporting evidence for the placement of protective stop loss orders.
These are just a few of the possible applications. As with many things related to the futures markets, a trader’s imagination is the only true limitation. Extensions may be integrated into an existing trading plan in any number of ways, conventional or not.
Getting Started with Fibonacci Tools
As with most technical indicators, those based on Fibonacci numbers are most effective when used as part of a comprehensive approach to the markets. Although they are certainly valuable, traditional fundamentals and other technicals are noteworthy as well.
