The Fibonacci tool is applied to a price move
When the price moves in any direction, the beginning and the end of that move can be clearly identified. Using the Fibonacci tool, you measure the distance of that move and the Fibonacci tool will automatically place what is called Fibonacci retracement and extension levels – these are explained in more detail later.
The actual calculations of the Fibonacci levels are based on the numbers in the Fibonacci sequence, or rather the percentage difference between them. However, for this lesson we will simply show you how to use this tool rather than explaining the mathematics behind it.
Start from the beginning of the price move to the end
The Fibonacci tool is applied manually. When measuring a downtrend, you apply the tool at the start of the move to the end – it is always applied from left to right. The chart below demonstrates this:
For an upward move, the tool is applied from the bottom and ending at the top – again it is always applied from left to right. The following demonstrates this on a chart:
Fibonacci levels are automatically placed in MT4
As you can see in the charts above, after the Fibonacci tool has been applied, it automatically places the Fibonacci levels between the start and the end of the move. These levels are referred to as retracement levels.
Fibonacci levels are shown as percentages of that total move. So the level that has been placed half way between the start and the end of the move is the 50% retracement level. So if the price then retraced halfway back, it is said to have retraced to the 50% level. This then acts as support or resistance, depending on which way the trend is.
The retracement levels therefore tell us how far the pull back could be.
In the chart below you can see the 38.2%, 50% and 61.8% levels. These are commonly used levels that the price could retrace back to, although there are other retracement levels that have been identified and work well.
Fibonacci retracement levels can be used for entries
As you can see from the chart below, the Fibonacci tool was applied to an uptrend and the 38.2%, 50% and 61.8% levels was placed in between the start and the end of the move. As these are levels that the price could retrace back to, you can then use them for potential entries.
How to choose the correct level to enter
There are two ways to choose which retracement levels you use to enter into the markets:
1. Aggressively enter as the price reaches each level.
You could enter at each retracement level placing a stop loss on the other side of the Fibonacci level. If your stop loss is hit, you simply enter again at the next level and carry on until the price goes back in your favour. This is an aggressive way of finding entries using the Fibonacci tool.
2. Wait until the price finds support or resistance at these levels first, and then enter.
You wait until the price finds support or resistance at these levels, wait for the price to move back in the original direction of the trend and then enter.
It is important to note that Fibonacci is not a trading system in itself – it has to be used in conjunction with or as part of a trading system.
Fibonacci extension levels
The Fibonacci tool is not only used to establish the retracement levels for traders as support or resistance; it can also project extension levels that show where the price could go to. Fibonacci extensions can therefore be used for profit taking or even counter trend entries.
The most common extension levels used by traders are the 138.2% and 161.8% levels, although there are many other extension levels used by different traders. The following is an example of extension levels in a downtrend.
The Fibonacci tool can be used to enter a position at one of the retracement levels when the price pulls back and then exit at one of the extension levels.
Below is a chart showing the extension levels of the Fibonacci tool applied to an uptrend. You can see the retracement and extensions levels.
Potential long entry at a retracement levelPotential exit at an extension levelHow to choose the extension level at which to take profit
The extension levels can be matched to the corresponding retracement levels to maximise profitability. For example, if the price retraced to the 38.2% retracement level, then the related extension level would be the 138.2.
Corresponding extension level at 138.2%
The related extension to the 50.0 or 61.8 retracement level is the 161.8.
Short entry at 50.0% retracement level Corresponding extension level at 161.8%
The first question you may ask is “why do Fibonacci retracement and extension levels correspond with each other?”. The answer comes back to a self-fulfilling prophecy. Banks and large financial institutions will look to take their profit at some point and targeting a Fibonacci extension level is one method they use. They will be expecting other banks and traders to exit at these levels and so based on these expectations, they do the same – hence a self-fulfilling prophecy.
However, it is important to note that this is not a fixed rule; for extension levels to work, they must be in a confirmed trend and this does not happen every time.
Using each level as a target
An easier method of using the extension levels is simply to exit when the price seems to find significant support or resistance there. In other words, if the price seems to have trouble breaking through a Fibonacci level, then this can be deemed a good exit.
