Whether you want to believe it or not, Fibonaccilevels play a critical role in defining support and resistance levels when day trading.
And determining support and resistance levelsis common problem faced by most traders.
Some of the common methods to determine supportand resistance include trend lines, moving averages, pivot points, Fibonacci retracementetc.
Today, you will learn how to determine hiddensupport and resistance levels using Fibonacci extensions.
Fibonacci series incorporates several analysistools on the basis of Fibonacci ratios and sequences showing geometrical law of humanbehavior and nature which is also applied to financial markets.
The Fibonacci study can be applied to identifyprobable support and resistance levels by studying Fibonacci numbers in various timeframes.
Fibonacci extensions, also referred to asFibonacci expansions, or Fibonacci projections, are external levels that go beyond the 100%Fibonacci level.
You may already be familiar with these importantFibonacci levels – 23.
0%, and 61.
These are considered internal retracementsthat are measured inside of a specific swing being analyzed.
But there are important Fibonacci levels thatextend beyond the 100% level and where price action tends to react often.
And these are what we call Fibonacci extensionlevels.
Fibonacci extension is drawn by joining threepoints unlike Fibonacci retracement which has just two points by joining the lowestand the highest points of a pre-defined trend and vice versa.
Let’s understand how we can draw Fibonacciextension in case of an uptrend.
You need to join the lowest and the highestpoint and then after a retracement or a correction, and the price continues in the direction ofthe original trend, the low of the retracement or a pullback would be our third point.
For example, looking at this chart, the pricemoved from here to here and after this the stock moves in the direction of the originaltrend.
So the first point to draw Fibonacci extensionwould be at point a, the point b will be here and the third point will be here, at the lowof the retracement.
This will give you probable resistance levelswhere the price may face resistance in the near future.
Let’s now consider a downtrend.
In this example you can see that we have abearish swing in price from point A to point B before price retraces part of this decline.
Once price has corrected to point C and thenbegun selling off again we can go ahead and apply our extension tool, mapping the swingfrom point A to point B and then back up to point C.
The most common Fibonacci extension levels are 161.
8% and 423.
Other important resistance levels using Fibonacciextension come at 50%, 61.
6% and 100%.
Fibonacci extensions are a way to establishprice targets or find projected areas of support or resistance when the price is moving intoan 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 areasof possible interest.
The price may not stop and/or reverse rightat the level, but the area around it may be important.
For example, the price may move just pastthe 1.
618 level, or pull up just shy of it, before changing directions.
If you are long on a stock and a new highoccurs, you can use the Fibonacci extension levels for an idea of where the stock maygo.
The same is true if you’re short.
Fibonacci extension levels can be calculatedto give you an idea on profit target placement.
You have the option to decide whether to coverthe position at that level.
It’s important not to confuse Fibonacciextensions with Fibonacci retracements.
What is the difference between Fibonacci extensionsand Fibonacci retracements? While extensions show where the price willgo following a retracement, Fibonacci retracement levels indicate how deep a retracement couldbe.
In other words, Fibonacci retracements measurethe pullbacks within a trend, while Fibonacci extensions measure the impulse waves in thedirection of the trend.
Let’s look at some of the practical examplesto gain more clarity about the concept of Fibonacci extension.
This is crude oil in the weekly timeframewith one Fibonacci extensions drawn on the above chart to show number of resistance identifiedusing the above logic.
At first we noticed that, the price facedresistance at 38.
2% extension and saw an immediate selloff.
Next 50% extension acted as a strong resistance, and you can see how the price rejected that area, almost to the pip.
We then have a double top at the 61.
8% extensionlevel, again, almost to the pip.
On its way down, observe how to price stoppedat the previous extension levels.
This is powerful stuff, and it’s a shamethat not many traders use this tool in their analysis.
Let’s move on the stock market and analyzea downtrend on Exxon mobile chart.
Here is the weekly time frame.
We have the starting point here, point b hereand the correction point here.
The extension levels are respected almostreligiously.
We have rejection at 38.
2% extension level, at 50% level, at 61.
8% extension and finally at 78.
Also, don’t neglect the fact that afterthe price rejected those extension levels, it stopped at previous levels, offering shortopportunities for those who wanted to trade in the direction of the main downtrend.
Here are other examples of Fibonacci extensionlevels on different markets.
So, how to use the fib extensionsYou can consider entering the market on fib extensions when the price reacts to a level.
This could be a bounce or a breakout.
If the price bounces from a Fibonacci extensionlevel, it is possible that price may be stalling or changing direction.
In this manner, you might be able to pursuea price move to the previous fib level.
In some cases, you will see the price clearlybreaking thru a Fibonacci extension level.
In this case, you may consider a trade inthe direction of the breakout and target the next extension level.
Essentially, you would trade Fibonacci levelsin a similar manner to other support and resistance levels.
The main difference is that fib levels areconsidered hidden levels of support and resistance that are not clearly recognizable to non-Fibonaccibased traders.
Stop loss orderAs a general rule, you can place your stop loss order at the next level beyond the onethat you are trading.
In the case when this distance may be toofar away from your entry point, then you can simply use a swing top/bottom that is closerto your entry point.
Take profit levelIn trading, there are no certainties.
We are dealing with possibilities and probabilities.
And so it is important to understand thatthere is no such thing as knowing exactly how far a price move will go.
You can always set a minimum target at thenext Fibonacci extension.
However, you will see that price will veryoften move farther than this, so you have to evaluate the market condition at each leveland act accordingly.
You do this by taking into account other factorssuch as volatility and average daily range, which can help in setting logical take profittargets.
The more volatile the market you are tradingis, the more likely it is to generate bigger moves.
Though Fibonacci is one of the useful methodsto analyze your chart but it doesn’t provide an exact entry point rather an estimated areaof entry.
Moreover, there is a no guarantee that theprice will reverse from any specified fib level and hence you should combine it withother technical parameters as a confirmation.
So use complementary indicators or patternswhen looking to determine one or multiple price targets because we don’t always knowwhich level the price will reverse from.
However, this tool gives us levels to monitor.
It is then down to you to use other elementssuch as confluence with other technical elements (trend lines, moving averages, indicator readingsor price action) to decide whether to trade the level.
Traders may differ in identifying the swinghigh and swing low points from which the extension levels are drawn, so there is some subjectivityinvolved here.
But the best way around these problems isto practice and practice! The point is that there is no one right wayto do it, but with a lot of practice, you’ll make better decisions of picking swing points.
Gradually you will get a feel for the trendand the overall technical picture.
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Until next time.