How to Use Fibonacci Retracement Levels & Extensions
Reading time: 8 minutes
Fibonacci ratios have become increasingly popular in the financial markets as they offer traders and investors a method of applying high-probability horizontal support and resistance levels across all asset classes and timeframes.
To implement Fibonacci ratios effectively, one must first understand trends and how to identify them. Once trend structure is identified, the trader can then begin looking at Fibonacci ratios, with many starting their journey using Fibonacci retracements and extensions.
The Fibonacci Retracement Ratio: A Simple Way to Start Trading
The Fibonacci retracement ratios are perhaps the more straightforward way to begin using Fibonacci in your trading. Successful application of these ratios relies on the trader determining the trend direction and locating two defined contact points.
The image below shows the basic setup for a Fibonacci retracement tool used in an uptrend, which includes the following ratios: 23.6%, 38.2%, 50.0%, 61.8%, 78.6%, and 88.6%.
Figure 1, the H1 chart for USD/JPY (US dollar versus Japanese yen), shows an example of an early uptrend beginning after the currency pair bottomed just north of ¥154.50. Using the swing low at point A (a higher low) and point B (a higher high), the trader can apply the Fibonacci tool from point A to point B to identify Fibonacci retracement ratios. In this example, price overlooked the 38.2% Fibonacci retracement ratio and the 50.0% retracement ratio (removed from chart) and rebounded from the 61.8% Fibonacci retracement ratio area and subsequently formed a fresh higher high to continue the uptrend.
As a note, the 38.2% Fibonacci ratio is calculated by dividing a number in the Fibonacci sequence by the next two higher numbers to produce 0.382, while the 61.8% Fibonacci ratio is computed by dividing a number in the Fibonacci sequence by the next higher number which will equate to approximately 0.618. Nevertheless, the 50.0% retracement ratio is not a Fibonacci number but can (and often does) hold price when tested.
Figure 1: USD/JPY H1 chart created using TradingView
You can also see from Figure 2 below – the same USD/JPY H1 chart as above – that you could, following the formation of the higher high (point B) and a sufficient correction, apply the Fibonacci tool from the new higher low (point A) to point B. As of writing, the 50.0% retracement ratio has held price. As long as the trend continues to form higher highs and higher lows, Fibonacci traders can use the Fibonacci tool to forecast potential reversal points within this uptrend. So, at the core of things, a Fibonacci retracement tool is applied during trending markets; traders look to exploit retracements within uptrends (buy into the dip from a ratio) and sell pullbacks within a downtrend from a ratio.
Figure 2: USD/JPY H1 chart created using TradingView
Is it possible to determine which Fibonacci ratio will hold? No. But there are ways to increase the odds of a ratio holding. This can be achieved either through additional technical tools converging with the same area as the Fibonacci ratio of interest or a Fibonacci cluster. The latter is an advanced technique that involves identifying Fibonacci retracement ratios, extensions, expansions and projections that cluster at a certain price level, thus adding weight to a possible reversal. Yet, this requires knowledge of different types of ratios, such as the Fibonacci extension.
The Fibonacci Extension Ratio: Expanding Your Knowledge
The Fibonacci extension tool is an extension of the retracement tool and is activated once price breaches 100% of the retracement. To simplify things, most traders (those who do not trade advanced harmonic patterns) tend to employ only the 1.272% and the 1.618% Fibonacci extension ratios. The former is the square root of 1.618 and the latter is the inverse of the 61.8% Fibonacci ratio.
Figure 3 shows the 15-minute chart of the USD/JPY. Upside momentum was strong following the low at ¥154.54 and subsequent to the higher low at ¥155.72 and the higher high at ¥156.48, a Fibonacci retracement tool could be applied from the higher low (point A) to the higher high (point B). As you can see, price failed to be contained between these two points and breached the higher low (thus the Fibonacci retracement tool offered limited support this time), which is where the Fibonacci extension tool helps.
In the case of this example, price found support between the 1.272% and 1.618% Fibonacci extension ratios at ¥155.25 and ¥155.52. From a psychological standpoint, the breach of the higher low (point A) likely filled stops from buyers who positioned stop-loss orders below the higher low (common), causing traders to close their buy positions and sell. This momentum (liquidity) pushing price action lower can be something larger traders seek to buy into, and a support area derived from the Fibonacci extension ratios can help them pinpoint potential reversal points.
Figure 3: USD/JPY 15-minute chart created using TradingView
Adding weight to a reversal at the Fibonacci extension ratio zone in Figure 3, a trader could have found additional confluence by applying a 50.0% retracement ratio from points A and B (green). As shown in Figure 4 below, the 50.0% retracement ratio shared chart space with the 1.272% Fibonacci extension at ¥155.49. Ideally, traders look for at least three Fibonacci ratios to form a cluster. Despite this, the example below does help illustrate how a trader can combine retracement and extension ratios to locate support and resistance areas.
Figure 4: USD/JPY 15-minute chart created using TradingView
Should I Use Fibonacci Ratios?
Experienced technical analysts seldom rely on one indicator or drawing tool to generate trading decisions. Therefore, the question should be whether Fibonacci ratios add value to your trading strategies. Only a thorough backtest can answer this question.
One way to include Fibonacci ratios in your trading is to use them to complement support and resistance levels. For instance, using the example in Figure 1 (above), Figure 5 shows the trader used the 61.8% Fibonacci retracement ratio to complement a trendline support. In this instance, the Fibonacci ratio was used as additional confirmation.
Figure 5: USD/JPY H1 chart created using TradingView
Fibonacci FAQs:
1. What are Fibonacci ratios?
Fibonacci is a series of numbers where each number in the sequence is the sum of the previous two values. By performing simple math with these numbers, certain ratios appear which can be used to trade the financial markets.
2. What is a Fibonacci retracement ratio?
A Fibonacci retracement ratio is found by applying the Fibonacci tool from higher lows to a higher high in an uptrend and from lower highs to lower lows in a downtrend. Ultimately, this tool is used to locate support and resistance in line with the trend.
3. What is a Fibonacci extension ratio?
A Fibonacci extension ratio is an extension of the Fibonacci retracement tool. It can provide support and resistance once price has retraced 100% of the move from a swing low (high) to a swing high (low) in an uptrend (downtrend).
4. Can I use Fibonacci ratios in isolation?
Using any technical tool in isolation is seldom suggested. Combining Fibonacci knowledge with other technical indicators and trend studies generally increases the chances of an area holding.
5. Where can I learn more about Fibonacci?
If you want to know how to calculate these ratios manually and want to explore more about the Fibonacci ratios, check out this video by FP Markets analysis, Aaron Hill.
