Retracements and extensions
Fibonacci retracements and extensions are displayed by first drawing a trendline between two extreme points, which usually are a swing high and swing low of recent move. A series of 11 horizontal lines (sometimes fewer, depending on the scale of the chart and the size of the moves being assessed) is drawn intersecting the trendline at the Fibonacci levels of 0.0%, 23.6%, 38.2%, 50%, 61.8%, 78.6%, 100%, 123.6%, 138.2%, 150% and 161.8%.
After a significant price move (either up or down), prices will often retrace a significant portion (if not all) of the original move. As prices retrace, support and resistance levels often occur at or near the Fibonacci retracement levels.
Fibonacci extensions work best when stocks are at new highs or new lows, where there aren’t any obvious support or resistance levels on the chart. If you are long a stock and it begins to make new highs, and you want to take profits, you can calculate the extension levels to get a general idea of where it may begin to fall.
In “Line break” (below), Fibonacci retracement lines were drawn between $1,334.00 and $1341.50, which were a swing high and a swing low. The rally from the lowest low ($1,334.00) to the high ($1341.50) was a difference of $7.50. The most common Fibonacci ratios are 0.382, 0.50 and 0.618, which allow us to calculate the key Fibonacci support levels.
38.2% Support: $1341.5 – (0.382 x $7.5) = $1338.6
50% Support: $1341.5 – (0.50 x $7.5) = $1337.5
61.8% Support: $1341.5 – (0.618 x $7.5) = $1336.8
As a result, those who went short once gold was unable to break the swing high for 15 minutes could have used a stop at swing high of 1341.5, for a target of 38.2%, 50% and 61.8%, respectively. As seen above, shorts all three targets were achieved.
We can see how Fibonacci extensions work in a recent example using the CNX Nifty. The Indian stock index breached its all-time high of 6415 on March 7, 2014. Traders might use Fibonacci extensions to identify the next target. As seen in “How high?” (below), the next day the index made a new high at exactly the 123.6% extension.
Fibonacci studies are used to identify potential support, resistance or reversal points. No indicator is perfect. This is why chartists must use other tools to confirm what Fibonacci analysis is telling us. Some useful tools include oscillators, moving averages and traditional chart patterns, such as triangles, head-and-shoulders formations and candlestick relationships. Any time one of these indicators corresponds at a specific price point with another, it adds to the importance of that level especially if it occurs with strong volume.
Bramesh Bhandari writes at www.brameshtechanalysis.com and provides online tutoring on technical analysis. He can be reached via e-mail at firstname.lastname@example.org.