Fibonacci numbers, or the Fibonacci sequence, is a numeric device credited to Italian mathematician Leonardo of Pisa dating to the late 12th and early 13th century. In simplest terms, the Fibonacci sequence is a collection of integers in which each consecutive integer is the sum of the previous two. Applications of principles related to the Fibonacci sequence are present throughout mathematics and geometry, as well as in nature.
In the world of active trading, Fibonacci Retracements and Expansions are two of the most commonly implemented mechanisms of technical analysis. While each tool is unique in form and function, the concepts of price retracement and ratio analysis are keys to conducting productive Fibonacci studies.
What Are Fibonacci Expansions?
Fibonacci Expansions are one method of calculating the size and extent of a forthcoming move in price. In order to derive a set of Fibonacci Expansion levels for a specific pricing fluctuation, a trader must identify the following elements:
- Extreme price points: The extreme high and low price points of a particular trend must be established. These levels are readily identifiable visually because they mark the absolute high and low of the trend or price move in question. The corresponding high and low values place the price movement into context, providing a basis to project a pending directional move.
- Retracement levels: The concept of pricing retracement is crucial to the construction of Fibonacci expansions. A retracement is a countertrend move occurring within a larger trend. Commonly referred to as either a “pullback” or “correction,” retracements are crucial to establishing Fibonacci expansion levels because once the retracement is exhausted, trend continuation becomes a possibility.
The primary objective of a Fibonacci expansion is to establish price levels that are likely to be achieved by the current market dynamic. In contrast to Fibonacci retracement levels, where identifying likely exhaustion points for an ongoing market correction is the focal point of the study, Fibonacci expansions view the relationship between a price retracement and the dominant trend as a precursor for an extension of price action itself.
It is due to this discrepancy that traders use Fibonacci expansions to identify optimal profit targets and potential future resistance levels instead of areas associated with support, conducive to the placement of protective stop losses.
Fibonacci Expansions: Trading Applications
Constructing a Fibonacci expansion is a relatively straight forward task, with modern trading software providing automated functionality. Simply put, all the trader has to do is execute a few mouse clicks connecting a trend’s high, low and relevant retracement level.
After identifying the desired price points, a trader calculates the expansion levels, and they are plotted on the pricing chart automatically. Typically, user-defined expansion levels are related to a function of Fibonacci numbers, known as the “golden ratio.” The value of the golden ratio is 1.618, and is incorporated into the popular expansion levels of .618, 1.000, and 1.618. Each level represents a potential destination of future pricing movements, making them prime candidates for the placement of profit targets.
Pros and Cons
Fibonacci expansions are a relatively basic method of quantifying trade management. Through establishing definitive profit targets and possible areas of resistance, a trader can combine expectations into a comprehensive trading strategy. Fibonacci expansions are also easy to use via software trading platforms and are especially effective in the trade of volatile, liquid markets such as in futures.
However, there are a few drawbacks. First, accurately measuring the pending follow-through of price action is largely ignored by Fibonacci expansions. In slow or consolidating markets, achieving price extension can be elusive, limiting the utility of defined expansion levels. Also, properly diagnosing optimal trend and retracement conditions can prove challenging to inexperienced practitioners of technical analysis.
As with nearly all things trading, practice and preparation are key aspects of successfully integrating Fibonacci expansions into a viable trading strategy.