What are Fibonacci Extensions?
Fibonacci Extensions are the levels of support and resistance used by traders to identify potential profit targets and estimate a continuation of a price movement after a pullback or reversal. Fibonacci extension levels are highly useful in understanding reversals and possible obstructions in price continuations. To put it in layman’s terms, Fibonacci extension levels are the key areas where the price of a particular asset might reverse from.
Fibonacci extensions can be highly utilized in different trading strategies and trading styles. These extensions can validate significant support and resistance levels as well as find potential reversal points and trend reversal areas. A combination of support and resistance levels with the Fibonacci extension tool can greatly help traders elevate their game and increase their consistency. As Fibonacci extensions can be used on all and any time frames, a convergence of different extensions on different time frames on the same key level can make that extension a very crucial and important area. Extensions can be drawn out on the chart by simply using the Fibonacci Extension indicator and in this next section I’m going to breakdown how to analyze certain Fibonacci levels.
Looking at Cardano (ADA) on the daily (1D) time frame, I’ve already went ahead and drew out the necessary support & resistance levels, accumulation & distribution areas, as well drew out the Fibonacci Extension indicator. To properly draw the extension, we first need to understand that there are 3 major points: the start of the uptrend, the swing high of the local top, and the swing low of the local top.
First, I marked out the start of the uptrend on November 20th, along the bottom body of that candle, not the wick. Next, I connected this point to the body of the local top and then had the drawdown stopping at the body of the swing low of the local top, for the 3rd point. This is the same process for every chart and with enough practice, this process becomes as easy as drawing simple levels of support and resistance.
How Traders Analyze Fibonacci Extension Levels
For traders and investors, the important feature to note is that the ratio between numbers is close to 1:1.61, the Golden Ratio.
If you divide any number in the series by the number two spaces to the right, you get a ratio of 38.2. This can also be obtained by subtracting .618 from 1. The third common ratio for extensions is 50%, this is not a number from the Fibonacci series of numbers but is included in the analysis when analyzing financial instruments.
These numbers, the 61.8 and 38.2 ratios along with the 50%, form the basis of the Fibonacci Extension indicator.
By looking at the prior highs and lows of the previous move, investors and technical analysts use Fibonacci extensions to determine how far a current bullish momentum will last in the market before a reversal.
Limitations of Using Fibonacci Extensions
Fibonacci extensions and retracements are not meant to be the sole determinant of whether to buy or sell an asset. 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 exepcially informative when trying to determine whether an asset is likely to reverse at the target price.
There is no assurance that the price will reach or reverse at a given extension level. Even if it does, it is not evident before a trade is taken in which the Fibonacci extension level will be important. The price could move through many of the levels with ease, or not reach any of them. This is why you have to properly identify levels of support & resistance before applying the Fibonacci Extension & Retracement indiacator to your chart.