How to use Fibonacci Retracements
The Fibonacci retracements pattern can be useful for swing traders to identify reversals on a stock chart. On this page we will look at the Fibonacci sequence and show some examples of how you can identify this pattern.
Fibonacci numbers were developed by Leonardo Fibonacci and it is simply a series of numbers that when you add the previous two numbers you come up with the next number in the sequence. Here is an example:
1, 2, 3, 5, 8, 13, 21, 34, 55
See how when you add 1 and 2 you get 3? Now add 2 and 3 and you get 5, and so on. So how does this sequence help you as a swing trader?
Well, the relationship between these numbers is what gives us the common Fibonacci retracements pattern in technical analysis.
Fibonacci retracements pattern
Stocks will often pull back or retrace a percentage of the previous move before reversing. These Fibonacci retracements often occur at three levels: 38.2%, 50%, and 61.8%. Actually, the 50% level really does not have anything to do with Fibonacci, but traders use this level because of the tendency of stocks to reverse after retracing half of the previous move. Here is an example using a graphic explaining the retracement pattern:
This picture shows a graphical representation of the reversal points for stocks in an uptrend. The pattern is reversed for stocks that are in down trends.
After a stock makes a move to the upside (A), it can then retrace a part of that move (B), before moving on again in the desired direction (C). These retracements or pullbacks are what you as a swing trader want to watch for when initiating long or short positions.
Once the stock begins to pull back (retrace), then you can plot these retracement levels on a chart to look for signs of a reversal. You do not automatically buy the stock just because it is at a common retracement level! Wait, and look for candlestick patterns to develop at the 38.2% area. If you do not see any signs of a reversal, then it may go down to the 50% area. Look for a reversal there. You do not know if or when the stock will reverse at a Fibonacci level! You just mark these areas on a chart and wait for signal to go long or short.
How to draw a fib grid
So how do we identify Fibonacci patterns on a chart. Easy, we draw a Fibonacci grid (fib grid) using swing points. Here is an example:
Draw the fib grid from the swing point high and the swing point low of a swing. Your charting software should come with this feature. It is a standard option on most charting packages. If not, you can calculate it manually by using this formula:
Calculate the range from the swing point high to the swing point low.
Now multiply the range times a Fibonacci ratio: 38.2% (0.382), 50% (0.500), and 61.8% (0.618).
Finally, subtract that number from the swing point high. That will give you your Fibonacci levels.
This chart shows an actual trade that I made. HS pulled back into the TAZ and then formed a bullish engulfing candle right at the 50% level. That gave me the signal to go long. Nice trade!
Is it useful?
Most of the time, when you draw a fib grid on a chart, you will notice that the grid lines up with support and resistance areas that you would see anyway without drawing the lines in! So you really do not need to draw the lines in. Instead, you can just look at a chart and estimate where the levels are.
Look again at the chart above of HS. If you didn't draw the Fibonacci retracement lines in, you can still tell just by looking at the chart that the stock has retraced 50% of the previous move.
If drawing the lines in helps you to better visualize the fib levels, then by all means use it! The choice is up to you.
How to Calculate Fibonacci Extensions
Most traders know what Fibonacci retracements are but you don't hear very many of them talking about Fibonacci extensions (at least I don't). If you have never heard of them, then get out a pen and some paper.
What is a Fibonacci extension?
Well, we know that a retracement is a move in a stock that retraces a portion of the previous move. Usually a stock will retrace at one of 3 common Fibonacci levels - 38.2%, 50%, and 61.8%.
But what happens when a stock retraces more than 100% of the prior move? In that case, you can calculate a Fibonacci extension
Take a look at this chart...
In the first example, AIR pulls back from $25.92 (1) to $23.11 (2). It then rallies above that swing point high at $25.92 (2). So this stock has recaptured more than 100% of the move from 1 to 2. It then tops out at $26.68 (3).
Could we have known that this stock might run into resistance at $26.68 (3)? Yes - If we calculated a Fibonacci extension ahead of time.
Take the difference in price between 1 and 2. In this case: $25.92 - $23.11 = $2.81
Now take that difference, $2.81 and multiply it by 1.272. $2.81 x 1.272 = $3.57
Now add $3.57 to $23.11 (2) and you get...
$26.68 - the exact high at 3. That is the Fibonacci extension.
In the second example...
$28.75 - $25.00 = $3.75 x 1.272 = $4.77 + $25.00 = $29.77. We are off by three cents here.
So, if you buy pullbacks and you are wanting to take partial profits on a stock, you can calculate this ahead of time.
Note: The two common Fibonacci ratios used for calculating extensions are 1.618 and 1.272. There are others but these seem to work the best.
Here is an example on how to calculate this for stocks finding support but this time we will use the 1.618 Fibonacci ratio:
$28.91 (2) - $26.84 (1) = 2.07
2.07 x 1.618 = $3.35
$28.91 - $3.35 = $25.56
Microsoft actually reversed at $26.76 (3). Close, indeed. Now, let's look at the next one on the same chart.
$28.00 (2) - $25.67 (1) = 2.33
2.33 x 1.618 = $3.77
$28.00 - $3.77 = $24.23
Microsoft actually reversed at $23.55 (3). Not too far off.
Calculating 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. So, 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.
Same thing on the short side. If you are short a stock, you can calculate the extension levels to get an idea of where the stock may begin to rally. Then you can decide if you would like to cover your position at that level.
But you should never base any decision to buy or sell a stock based on Fibonacci alone. Wait for candlestick patterns (price action) to develop and confirm that the stock may indeed reverse at your target price.
Source By: Swing Trade Stocks