June 2, 2010
Fibonacci Extensions And Projections - A Live Trading Example
Many forex traders use fibonacci analysis to re-enter a trade in the same direction as the overall trend after there has been some kind of retracement. For instance if the price has been trending upwards but has recently fallen back, then many traders will look to enter a new long position after the price has fallen 23.6%, 38.2%, 50% or 61.8% of the original trend, ie from the low point to the high point.
However today I want to talk about another way you can use fibonacci in your trading, and that's by using fibonacci extensions to determine when a trend is likely to end. This is useful because it helps you exit existing positions and enter new positions to profit from any trend reversal.
The key fibonacci extension levels are 127.2%, 161.8%, 261.8% and 423.6% and you will often find that each of these levels will often act as solid, or at least temporary resistance if they are reached. The most significant level is the 161.8% level in my experience.
Plotting these fibonacci extensions on your chart is relatively straight forward nowadays because most charting software come with some kind of fibonacci tool.
In an uptrend you are basically looking for a swing high followed by a retracement. Then you simply use the fibonacci tool to join the swing high to the subsequent swing low of the retracement. This should then give you the 127.2%, 161.8%, 261.8% and 423.6% fibonacci extensions where the price is likely to run into resistance if it continues heading higher.
You can then exit any existing positions when one of these levels is reached, or possibly exit half your position at 127.2% and the other half at the 161.8% level, for instance.
There is no right or wrong way to trade these levels but it's amazing how often the price reacts around these key fibonacci extensions.
You can apply these fibonacci extensions to any time frame but I think they are most useful on the shorter time frames because then you can combine them with pivot points to find SUPER-STRONG areas of support and resistance.
For instance if the price has moved up to the pivot point and there is also a key 161.8% fibonacci extension very close to this pivot point, this would be a great place to enter a short position because it is clearly a very strong resistance level.
This is exactly what I did on the EUR/GBP pair earlier today. As you can see from the 5 minute chart below, the price trended upwards and hit a high (0.8360) at 11.10 before retracing back again to form a new swing low (0.8318) at 12.15. So by using the fibonacci tool between these two points you get fibonacci extensions of 0.8372 and 0.8387 for the key fibonacci levels of 127.2% and 161.8% (indicated by the dotted blue lines).
I only came across this set-up at around 15.30 this afternoon, but I quickly noticed that after using the fibonacci tool to plot these extensions, the two key levels just mentioned were both very close to the pivot point (indicated by the thick black line), which by itself is often a good resistance level anyway.
So when the price approached 0.8380 I figured that this would be a great low-risk entry point for a short position and the real clincher was that the average daily range for this pair is currently around 100-110 points (according to the ATR indicator) and the range for today was already around 100 points. Therefore I thought that there was unlikely to be much more upside left.
So in the end I went short at 0.8377 (and added to my position about 10 minutes later at 0.8375) and targeted a 20 point retracement. I placed my stop loss 5 points above the 161.8% level at 0.8392.
As you can see this trade worked out perfectly and I was automatically closed out of both positions as soon as they hit my target of 20 points. The price actually fell all the way back to 0.8327 but it's always impossible to call the top and the bottom. Besides you only need to catch a small chunk of a particular price move in order to make consistent profits.
Anyway the point I want to make is that as I've recently discovered, fibonacci extensions are a great tool for determining when a particular trend is likely to come to an end. Plus if you apply them to the intraday time frames, you can use them in conjunction with pivot points to find strong areas of support and resistance where the odds are firmly stacked in your favour.