Fibonacci Extensions and Retracements

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Fibonacci Retracement Levels

What Are Fibonacci Retracement Levels?
Fibonacci retracement levels are horizontal lines that indicate where support and resistance are likely to occur. They are based on Fibonacci numbers. Each level is associated with a percentage. The percentage is how much of a prior move the price has retraced. The Fibonacci retracement levels are 23.6%, 38.2%, 61.8%, and 78.6%. While not officially a Fibonacci ratio, 50% is also used.

The indicator is useful because it can be drawn between any two significant price points, such as a high and a low. The indicator will then create the levels between those two points.

Suppose the price of a stock rises $10 and then drops $2.36. In that case, it has retraced 23.6%, which is a Fibonacci number. Fibonacci numbers are found throughout nature. Therefore, many traders believe that these numbers also have relevance in financial markets.

KEY TAKEAWAYS
Fibonacci retracement levels connect any two points that the trader views as relevant, typically a high point and a low point.
The percentage levels provided are areas where the price could stall or reverse.
The most commonly used ratios include 23.6%, 38.2%, 50%, 61.8%, and 78.6%.
These levels should not be relied on exclusively, so it is dangerous to assume the price will reverse after hitting a specific Fibonacci level.
The Formula for a Fibonacci Retracement Level
Fibonacci retracement levels do not have formulas. When these indicators are applied to a chart, the user chooses two points. Once those two points are chosen, the lines are drawn at percentages of that move.

Suppose the price rises from $10 to $15, and these two price levels are the points used to draw the retracement indicator. Then, the 23.6% level will be at $13.82 ($15 – ($5 x 0.236) = $13.82). The 50% level will be at $12.50 ($15 – ($5 x 0.5) = $12.50).

How to Calculate Fibonacci Retracement Levels?
As discussed above, there is nothing to calculate when it comes to Fibonacci retracement levels. They are simply percentages of whatever price range is chosen.

However, the origin of the Fibonacci numbers is fascinating. They are based on something called the Golden Ratio. Start a sequence of numbers with zero and one. Then, keep adding the prior two numbers to get a number string like this:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987… with the string continuing indefinitely.
The Fibonacci retracement levels are all derived from this number string. After the sequence gets going, dividing one number by the next number yields 0.618, or 61.8%. Divide a number by the second number to its right, and the result is 0.382 or 38.2%. All the ratios, except for 50% (since it is not an official Fibonacci number), are based on some mathematical calculation involving this number string.

Interestingly, the Golden Ratio of 0.618 or 1.618 is found in sunflowers, galaxy formations, shells, historical artifacts, and architecture.

What are Fibonacci Extensions?
Fibonacci extensions are a tool that traders can use to establish profit targets or estimate how far a price may travel after a retracement/pullback is finished. Extension levels are also possible areas where the price may reverse.

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.

Fibonacci Retracements Thinkorswim

Fibonacci Extensions Thinkorswim

KEY TAKEAWAYS

Common Fibonacci extension levels are 61.8%, 100%, 161.8%, 200%, and 261.8%.

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.
The Formula For Fibonacci Extensions
Fibonacci extensions don’t have a formula. When the indicator is applied to a chart the trader chooses three points. Once the three points are chosen, the lines are drawn at percentages of that move. 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.

How to Calculate Fibonacci Retracement Levels
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.

What Do Fibonacci Extensions Tell You?
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 time frame 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.

The Difference Between Fibonacci Extensions and Fibonacci Retracements
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.

Limitations of Using Fibonacci Extensions
Fibonacci extensions are not meant to be the sole determinant of whether to buy or sell a stock. It is advisable for investors to 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.

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