Traders & Investors Club

In the last section, we looked the theory behind the Fibonacci percentages. Part 2 will look at how these Fib percentages can be applied to your trading.

Fibonacci can be applied in many ways when trading, but the two key approaches we are going to study in this section are Retracements and Extensions.


What is a retracement?
A retracement is when the market moves in one direction and then changes to move back in the opposite direction. The second move in the opposite direction is called the “retracement”. This is obviously a pretty simple concept and something regularly seen on any chart. Let’s take a look at a retracement of a recent fall in the value of the GBP/USD (also known as “Cable”) currency pair.

The market fell from Point X to Point Y, about 900 pips. It subsequently retraced this move by 500 pips before pushing on in the original downtrend. The second move up from Point Y is the Retracement.

Now let’s see if there is a fit with the Fibonacci percentages. When you hear the term “Fibonacci Retracement” it means that the amount the market moves in the retracement phase corresponds to one of the Fibonacci percentages, such as 38.2% or 61.8%.

Looking at the same retracement of GBP/USD, 61.8% clearly acts as a major level that defines the size of the retracement. That means the currency moved from Point X to Point Y, and then moved back 61.8% of the original distance.

Of course, a retracement can extend beyond 100%, i.e. go past the size of the original move. Let’s take another starting point on the same currency. Take a look at the final push up highlighted by the red arrow before Cable moved down to Point Y.

Now, let’s look at the Fibonacci percentages beyond 100%. As can be seen on the chart, 123.6% is another clear Fibonacci level for the retracement.

This Fibonacci level, at approx 1.5045, confirms the previous one defined by the 61.8% retracement from Point X to Point Y. Here’s a combined chart:

Spotting this area as a key Fibonacci level, even after the price had bounced off it, offered an achievable 500 pips of trading profits.


What is an extension?
An extension of a trend is exactly what it sounds like – the price moves, retraces, and then extends in the original direction. So the Extension is the portion after the retracement.

How do we measure the Fibonacci percentages of an extension? You measure the size of the original move (Point X to Point Y) from the end of the retracement or the beginning of the extension. This gives you potential targets to where the extension could go on to.

On MetaTrader, you can create the extensions by going to the menu bar at the top:
Insert > Fibonacci > Expansion
(MetaTrader calls Fibonacci Extensions “Expansions”.)

So looking at the next chart, you start measuring the Fibonacci levels from Point Z, the start of the extension. On this chart, the value of Cable bounces neatly off the 88.6% Fibonacci extension level. What that means is that the price moves from Point X to Point Y, then moves up to Point Z, and then moves down covering 88.6% of the distance between Point X and Point Y before moving back up again. You may need to read that last sentence over a couple of times, but it explains exactly the logic of Fibonacci Extensions.

This Fibonacci extension level, at approx 1.4245, is confirmed in several ways. If you picked at the previous high prior to Point X (marked with a blue line on the next chart) as your starting point instead of Point X, you can see the price bounces off the 78.6% Fibonacci Extension.

Here is yet another confirmation – shortly after Point X, the price popped up to make a small high (marked with a red arrow), before making its final descent to Point Y.

Using that small high as a starting point, the recent bottom in Cable is a 100% price extension.

And finally, here is a combined chart:

Now the lines are so close together, you can barely make them out. The Fibonacci analysis pointed in advance to this level being an area of support.


All the examples in this section are using Fibonacci levels discussed in my previous post, Part 1. For the sake of clarity on these charts, I have removed the other Fibonacci percentages when showing a retracement or extension. When I am analysing my own charts from scratch, I will be using all the Fibonacci points discussed in my previous post (Part 1). I will be picking off major highs and lows, usually on the 1 hour and 4 hours, and occasionally 15 minute charts, to find my levels. I am particularly interested at points where the Fibonacci levels meet, and interested most in the 61.8%, 78.6% and 88.6% levels.

Depending on my view on the market, I may use a Fibonacci cluster to place a trade, or avoid the cluster if I first need to see it rebound or broken. For example, if I wish to go long, but there is a Fibonacci cluster a few pips away, I will either wait until it is broken, or wait for a better (lower) entry to give myself more room to manoeuvre. Never trade without stops and keep an eye on your risk/reward ratio always.

hamid@simplyprofit.net