Identifying Powerful Reversal Locations With Fibonacci Extensions

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Fibonacci analysis continues to be one of the most popular and effective forms of technical trading. Fibonacci analysis is built around the famous mathematical sequence which measures structures and formations based on Fibonacci’s “Golden Ratio”.  This ratio can be found in a vast range of structure from star formations, flowers, and shells through to man-made structures and financial markets.

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Fibonacci Extension

In terms of Fibonacci trading tools (which are inbuilt on the MT4 platform) we’ve previously looked at Fibonacci retracements and how useful they can be for gaining entries to trends. In this session, we are going to step things up a level and explore Fibonacci extensions.

Finding The Tool

From the toolbar along the top of your terminal select Insert > Fibonacci > Expansion.

While the tool itself is a little different (we’ll get to that shortly), the premise behind it is exactly the same as with the Fibonacci retracement tool. We are simply measuring swings in price and using the tool to plot potential levels of interest which can be used in our trading.

The only difference Is that with the retracement tool we measure from point A to point B and with the extension tool we are measuring from A to B and then back to C (which will always be somewhere between A and B).

Bullish Extension

In the example above you can see that we have a bearish swing in price from point A to point B before price retraces part of this decline. However, the recovery stalls and price then resumes the bearish move, breaking below the low at point B to trade fresh lows before again seeing some correction higher.

Once price has corrected to point C and then begun selling off again we can go ahead and apply our extension tool, mapping the swing from point A to point B and then back up to point C and you can see this automatically plots some levels on our chart.

These levels are the 61.8% 100% and 161.8% extension of the price move from A to B as projected from point C. These levels can often be key turning points for price and the two key levels to focus on are the 100% and 161.8% extensions.

As you can see in the example, price trades down below point B, hits the 100% extension level and then reverses sharply. As such, in this example, the extension levels offer key support levels at which traders can look to buy price.

Similarly, if traders are already trading the bearish move, these extension levels can be used as points for taking profits or moving stops down because traders are aware of the risk of a reversal.

Bearish Extension

In this example, you can see we have the bearish version. This time we are tracking a bullish move in price from point A to point B and the correction to point C before the bullish move resumes. When price is moving higher like this we can use the extension tool to identify levels which could serve as bearish turning points.

So, again, we apply our Fibonacci extension tool from point A to point B and back down to point C, which automatically highlights the extension levels on our charts. This time, you can see that price doesn’t reverse at the 100% extension. However, we do see a strong bearish reversal from the 161.8% level.

Determining Which Level To Trade

This raises a key point, which is that we don’t always know which level (if any) price will reverse from. However, the tool gives us levels to monitor. It is then down to the trader to use other elements such as confluence with other technical elements (trend lines, mobbing averages, indicator readings or price action) to decide whether to trade the level.

Hopefully, this tutorial has shown you just how simple and effective Fibonacci extensions can be. These levels are incredibly useful not only for identifying potential entry points to the market, but also for giving us levels to monitor in terms of trade management such as profit targets, or levels at which to move stops.

 

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