Fibonacci extensions are a tool that traders can use to establish profit targets or estimate how far a price may travel after a pullback is finished. Extension levels are also possible areas where the price may reverse.
The Fibonacci extensions show how far the next price wave could move following a pullback.
Fibonacci ratios are common in everyday life, seen in galaxy formations, architecture, as well as how some plants grow. Therefore, some traders believe these common ratios may also have significance in the financial markets.
Extension levels signal possible areas of importance, but should not be relied on exclusively.
Fibonacci extensions don’t have a formula. When the indicator is applied to a chart the trader chooses three points. 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 retracement against that move. The extensions then help project where the price could go next. Once the three points are chosen, the lines are drawn at percentages of that move.
Extensions are drawn on a chart, marking price levels of possible importance. These levels are based on Fibonacci ratios (as percentages) and the size of the price move the indicator is being applied to.
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Multiply the difference between points one and two by any of the ratios desired, such as 1.618 or 0.618. This gives you a dollar amount.
If projecting a price move higher, add the dollar amount above to the price at point three. If projecting a price move lower, subtract the dollar amount from step one from the price at point 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. The Fibonacci levels will then be projected out above $15, providing levels to the upside of where the price could go next. If instead, the price drops, the indicator would need to be redrawn to accommodate 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 on the indicator, then the 61.8% level will be $6.18 (0.618 x $10) above the price chosen for point three. In this case, point three is $15, so the 61.8% extension level is $21.18 ($15 + $6.18). The 100% level is $10 above point three for an extension level of $25 ((1.0 x $10) + 15).
The ratios themselves are based on something called the Golden Ratio.
To learn about this ratio, start a sequence of numbers with zero and one, and then add the prior two numbers to end up with a number string like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987…
The Fibonacci extension levels are derived from this number string. Excluding the first few numbers, as the sequence gets going, if you divide one number by the prior number, you get a ratio approaching 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 to the left and the ratio is 4.236.
The 100% and 200% levels are not official Fibonacci numbers, but they are useful since they project a similar move (or a multiple of it) to what just happened on the price chart.
Fibonacci extensions are a way to establish price targets or find projected areas of support or resistance when the price is moving into an area where other methods of finding support or resistance are not applicable or evident.
If the price moves through one extension level, it may continue moving toward the next. That said, Fibonacci extensions are areas of possible interest. The price may not stop and/or reverse right at the level, but the area around it may be important. For example, the price may move just past the 1.618 level, or pull up just shy of it, before changing directions.
If a trader is long on a stock and a new high occurs, the trader can use the Fibonacci extension levels for an idea of where the stock may go. The same is true for a trader who is short. Fibonacci extension levels can be calculated to give the trader ideas on profit target placement. The trader then has the option to decide whether to cover the position at that level.
Fibonacci extensions can be used for any timeframe or in any market. Typically, clusters of Fibonacci levels indicate a price area that will be significant for the stock, and also for traders in their decision making. Since extension levels can be drawn on different price waves over time, when multiple levels from these different waves converge at one price, that could be a very important area.
While extensions show where the price will go following a retracement, Fibonacci retracement levels indicate how deep a retracement could be. In other words, Fibonacci retracements measure the pullbacks within a trend, while Fibonacci extensions measure the impulse waves in the direction of the trend.
Fibonacci extensions are not meant to be the sole determinant of whether to buy or sell a stock. Investors should use extensions along with other indicators or patterns when looking to determine one or multiple price targets. Candlestick patterns and price action are especially informative when trying to determine whether a stock is likely to reverse at the target price.
There is no assurance price will reach and/or reverse at a given extension level. Even if it does, it is not evident before a trade is taken which Fibonacci extension level will be important. The price could move through many of the levels with ease, or not reach any of them.