This article looks at how fibonacci extensions are calculated and how they can be used by forex traders. This is a follow up to How to Calculate and use Fibonacci Retracements in Forex Trading.
The first section looks at the Fibonacci sequence and how the extension levels are calculated. The second section provides examples of how extension levels can be applied to a chart and used to improve our trading. The third section is a video showing how fibonacci extensions levels are put on the chart and how they could have been used to make trading decisions.
Fibonacci Numbers and Ratios
Fibonacci numbers follow the sequence 1,1,2,3,5,8,13,21,34,55,89,144,233.. Where each number is the sum of the two preceding numbers.
The ratios that we use for fibonacci extensions are based on this number sequence. The most important ratios are:
233/144 = 161.8%
233/89 = 261.8%
233/55 = 423.6%
Many traders include 127.2% (square root of 161.8%) as a fibonacci extension level. I also like to look at the round numbers 200%, 300% and 400%.
What are Fibonacci Extensions and why do Traders Use Them?
Fibonacci extensions are used when prices extend beyond the swing high or low that was used to calculate the fibonacci retracement levels. Extension levels act as support and resistance in exactly the same way as fibonacci retracements do. Also, they act as a magnet to the price and can therefore be useful for setting profit targets for our trades.
Correctly identifying a trend and staying with it is probably the easiest way to make money trading any market. Fibonacci extensions are particularly handy for trend trading by encouraging us to focus on price moves beyond the current range.
As with fibonacci retracements, the price does not always respect extensions levels. Often the price will pass straight through these levels or reverse before them. The levels are still important because the price frequently does respect them.
In the EUR/USD weekly chart below, the price had been in an uptrend for the past 4 years. The charts shows a significant swing high at 1.2932 and then a swing low at 1.1761 which are used to draw the fibonacci levels.
The price finds resistance and the 50% level and then the 61.8% level before eventually rising above the swing high (100%). At this point we can use our extension levels to identify targets for long trades and possible reversal locations for short trades. In this case the price broke straight through the 127.2% before hitting the 161.8%, forming a shooting star reversal pattern and then moving strongly down.
The 4-hour chart below was also preceded by an uptrend. On this occasion the price found strong support at 1.3525 (0%) and very quickly broke above the swing high. The price then found resistance at 161.8% and settled into a range between this level and the breakout level (100%). After breaking above 161.8% the price then found resistance at 261.8% before falling back and then finding support at 127.2%.
Fibonacci extensions are very useful for day trading. The 15-minute chart shows how the price found some support and 161.8% before breaking down all the way to 423.6%.
Video: Using Fibonacci Extensions in Forex Trading
This video shows how fibonacci extensions could have been used to make sense of the price action and guide trade entries and exits.