In the world of technical analysis, investors and traders alike will adopt a variety of methods and tactics in order to gauge the performance of a market. While looking for an entry and exit into a market, tools such as the Fibonacci Retracement and Extension may be used.
Fibonacci, also known as Leonardo de Pisa, was a mathematician who thoroughly studied how math could be applied in nature. One of the results was the golden ratio as well as the Fibonacci sequence.
Just as the golden ratio appears in nature, it also appears in the financial markets. As such, these tools may be used to supplement other trading strategies in order to identify a support and resistance and the likelihood of retracement at certain levels to extensions at other levels.
A market is usually in trend, however, within a trend there will be a short term pullback or retracement back to certain support or resistance levels. Traders know that it may get confusing to identify at which level a trend would retrace to. Therefore, one of the filters that may be used is the fibonacci retracement tool.
Using the tool is quite simple. First, an analyst must identify a trend. The analyst must identify the swing high and the swing low of the trend. However, depending on the timeframe, this may be applicable to different legs of the trend.
A leg of a trend in this case is a large movement before and up to its next retracement pattern.
Once the high and the low has been identified, the trader may use the tool to see the fibonacci levels. The most common levels to look at are the 38.2% and the 61.8% retracement levels. Should these intersect with a previously identified support or resistance level, this will help to filter out the potential levels for entry.
It should be noted that the 50% retracement level is there as a psychological level, as traders like even and round numbers. A retracement of 50% is also valid in this sense.
When trading a trend it is difficult to identify the next target at which the market will move towards to in a trend continuation. What is commonly used is the next support or resistance level as the next target. However, the Fibonacci Extension tool will assist in filtering the appropriate levels just like the fibonacci retracement tool before.
When using the Fibonacci Extension tool, the principle is the exact same as the fibonacci retracement tool. First, one must identify the highs and lows of a given trend or leg of a trend. The trader may then map the tool onto their chart and start filtering the support and resistance levels using the given levels of a 127% and 161.8% extensions.
While the Fibonacci Retracement will help in finding an entry, the Fibonacci Extension will help in finding an exit. Using these tools will help to supplement a trend continuation strategy.