The Fibonacci Extension tool is a technical indicator which is found on most trading platforms and especially on the MetaTrader4 platform. The Fibonacci Extension is also known as the Fibonacci Expansion tool. It is used in a variety of ways, but sadly, many traders do not use this tool and it is left to exist on the MT4 platform as some sort of relic, which should not be. Traders who have a problem knowing exactly where to set their trade exit points, especially if those trades are set from retracement levels, will find this tool very useful, as we will soon see from the demonstration below.
We have seen the Fibonacci Retracement tool being used to trade the markets in a situation where the currency pair is in a strong trend, then retraces to a price level which is determined by the Fibo Retracement tool and then the entry made from that retracement point. The Fibonacci Extension tool is used to determine the Take Profit point of this new trade. As such, the Fibonacci Extension tool and its Retracement counterpart are supposed to be used in tandem with each other. Let us now demonstrate how to use the Fibonacci Extension tool to locate the trade exit point after the trader has entered a retracement trade.
HOW TO TRACE THE FIBONACCI EXTENSION TOOL ON A CHART
For the trader to accurately determine what the trade exit point from a retracement level should be, the trader has to be able to trace the Fibo Extension tool accurately. This is how to do it.
a) Trading a Retracement Long Entry.
A retracement long entry is a trade that aims to go long on a currency pair after it has been in an uptrend and then retraced to the downside. Use the Fibonacci Retracement entry rules we discussed in a previous blog post to setup the trade by applying the Stochastics oscillator to the chart, and tracing the Fibonacci Retracement tool from the swing low to the swing high. Mark off the area where the price retraces down to a Fibo retracement level at the same time that the Stochastics is oversold. Once the entry for the trade has been made, remove the Fibo retracement tool from the chart.
Next, pick up the Fibo Extension tool from the platform interface, and apply the tool from the swing low to the swing high and then finally to the retracement low. This will plot the following Fibo Extension levels on the chart:
– 161.8% and beyond
The two charts listed below show how this trade plays out.
This chart shows how to derive the proper retracement point using the Fibo Retracement tool. This is how the trade entry level is detected. Once the trade entry point is derived, the Fibo Retracement tool is removed from the chart and the Fibo Extension tool is opened. To do this on MT4, go to Insert –> Fibonacci –> Expansion/Extension. Then draw the tool from the swing low to the swing high and then drag the low point of the extension to the retracement low (which in the chart above is at the 50% level). The Fibo extension levels are then traced on the chart. You can reduce the magnification of the chart using the zoom tool to visualize these levels as we have done.
We can clearly see that the GBPUSD headed up to the 100% Fibo Extension level before it beat a retracement. That represents a good place for the trader to set the initial trade exit.
b) Trading a Retracement Short Entry.
A retracement short is a trade that aims to profit from a short entry made at a point where a currency pair in a previous downtrend has retraced to. The Fibonacci Retracement entry rules for a short trade should also be applied here. Select the Stochastics oscillator and apply it to the chart, and trace the Fibonacci Retracement tool from the swing high to the swing low. Mark off the area where the price retraces upwards to a Fibo retracement level at the same time that the Stochastics is overbought. Once the short entry has been made, remove the Fibo retracement tool from the chart. Then apply the Fibo Extension tool from the swing high to the swing low and then to the retracement high, which for the chart below is at the 61.8% level (not shown though). This will plot the Fibo Extension levels on the chart. This is how the chart will look like after these actions are performed:
On this chart, not only have we applied the Fibonacci Expansion tool to pick out the trade exit points, but we have also introduced another way that a Fibo Extension setup can be traded, and that is by sequentially entering and exiting trades at different extension levels that now serve as support and resistance, depending on whether they are found above or below the market price. We can see that the initial trade was served at the 61.8% retracement mark, with exit point at the 100% Fibo Extension level. The price now retraced all the way to the 100% mark (area of previous resistance), and this could have been another area to initiate a short trade, ending at the 100% Fibo extension mark.
Generally speaking, some experts have indicated that the following general guidelines for trade entries and exits using the retracement and extension tools of Fibonacci respectively should be used:
38.2% retracement – 161.8% level and beyond
50% retracement – 138.2% to 161.8%
61.8% retracement – Above 100% to 138.2%
100% retracement – 100% to below 138.2%
RULES FOR TRACING FIBONACCI EXTENSIONS
Some traders like to apply the Fibonacci tools to short term charts such as the one minute or hourly charts. This is wrong. The Fibonacci tools are traced from swings of price, and the only way to know what a true extreme of price is to determine such from a long term chart. You will notice when tracing the swing highs and lows on the long term charts that between a swing high and low on this long term chart, there will be many such swings on short term charts. These short term swings are nothing more than market noise and if the trader traces the Fibonacci Retracement or Extension tools on them, there will be many inaccurate signals. The Fibonacci Extension tools are therefore best drawn on long term charts such as the four-hour, daily or weekly charts.
So when in the market after making a Fibonacci Retracement entry, simply use the Fibonacci Extension tool to make the trade exit. Practice trading with the Fibo Extension tool in order to properly time your trade exits and not get caught out by retreating prices.