It’s believed that throughout nature there are a series of repeating patterns.
The number series that were found to generate these patterns were based on the Golden Ratio.
This Golden Ratio is found in galaxy formations, plant growth, and even in spectacular man-made architecture.
A man by the name, Leonardo Pisano Bogollo introduced this to Western society and to this day “Fibonacci levels” are found in financial markets.
Traders use the Fibonacci (Fib) retracement to find “hidden” levels in the market, allowing them to know exactly when to enter a trade and take profits.
It’s an often overlooked pattern, and if you haven’t been using this technical indicator… you might want to consider leveraging the power of the Fib retracement.
Fibonacci, or “Fib” numbers, assert that price is a wave, and has a mathematical relationship to past waves. In turn, it is also believed that these waves will also impact future prices in a similar wave pattern.
A quick introduction to Fibonacci numbers:
It’s cryptic, and I know… it’s mind-numbing… but it’s mathematically beautiful!
So how are these numbers generated? Well you see.. It’s quite simple once we break it down.
The next number in the sequence is the sum of the prior two numbers before it. Starting with the 3rd number, 1, it is calculated by adding 0 and 1. Two is calculated by adding 1 and 1. Three is calculated by adding 1 and 2.
And this number sequence continues indefinitely!
A Fibonacci Ratio or “Golden Ratio” is derived from this sequence. Using the Fibonacci numbers, we would take a number and divide by the prior number.
For example, a Fibonacci Ratio 1.5 is calculated by dividing 3/2, and 1.625 is calculated by dividing 13/8. As you progress, you will eventually reach the “Golden Ratio” of 1.618.
That’s great, but how does this generate Fibonacci Extensions?
Well, let’s start by understanding that price when applying any Fibonacci number or ratio causes two very important results.
- Fibonacci Retracement
- Fibonacci Extension
In this article we are going to be covering Fibonacci Extensions and how to utilize this key tool for markets at record levels.
There are an infinite number of Fibonacci Extension numbers. Some common levels that many traders live-and-die by are 61.8%, 100%, 138.2%, 161.8%, 200%, 238.2%, 261.8%.
Pro Tip: These Fibonacci levels are most accurate on popular, high liquid stocks, indexes, futures, and forex pairs.
Try to avoid any low volume instrument as they can be more easily manipulated by a single individual which may cause it to have erratic movements that don’t align with natural patterns.
Don’t worry, you’re in luck.
The days of having to calculate these levels by hand are gone.
All you have to do now is check your favorite charting package for easy to use fib levels. Many brokerage platforms have both automatic and manual Fibonacci tools!
What Do Fibonacci Extensions Tell You?
Fibonacci extension tools are one of the best ways to project future areas of support and resistance.
It is the key to trading markets at all-time-highs since there are no price levels for traders to use for reference.
Sometimes it’s hard to tell where a target is when momentum is in high gear. This tool is critical for finding targets during breakout trades.
How Do You Use Fibonacci Extension Tools?
Fibonacci Extension lines are typically manually drawn. Each trader identifies key levels as important but there are some general rules that you’d like to follow.
3 Key Tips For Placing Fibonacci Extensions
- Select a low made by recent and extreme prices
- Identify a top in the market that showed to be future resistance
- Finally (if possible) select the most recent pivot prior to current trend
In the SPY chart below, you can see how I selected these 3 key points for the FIb tool to calculate its prices from.
Selecting those key levels shows quite an interesting picture.
How do you read it?
Look how recently the price seemed to halt at 304.00 exactly on the SPY’s! That lined up with a resistance zone created by Fib 0.618 level.
As previously stated in my last letter, click here to read, The Truth Behind The Lies.
So now we entered the trade, it’s looking like 0.786 is a great place to start looking for a target to occur!
Interestingly, a lot of the times when I’m looking for levels using mySPY Trade of the Trade strategy, the levels I look for match up with a key Fibonacci level.
Some Limitations To Using Fibonacci Extensions
Remember traders, there is no single tool as magic beans. This is just one of many tools in my toolbox that I use to identify targets and areas of reversals when trading explosive momentum patterns.
There is no assurance that the price will reach and/or reverse at any given extension level.
Remember… Even if it does, it’s not exactly evident which Fibonacci extension level will be important as the price could move through many of them with ease before reversing. Keep your account protected and use strict risk management techniques!