Fibonacci retracement and extension analysis uncovers hidden support and resistance created by the golden ratio. Fibonacci grids prepackaged in most charting programs lay out these price levels, which act like traditional support and resistance but originate in mathematical proportion, rather than the highs or lows on a price chart. Many traders and investors dismiss Fibonacci as voodoo science, but its natural origins reveal poorly understood aspects of human behavior.
Fib math highlights proportionality, capturing the essence of beauty and packaging it into a set of ratios that can define seashells, flowers and even the facial structure of Hollywood actresses. This analysis extends into the measurement of trend and countertrend swings that carve proportional ranges, pullbacks and reversals. In its market applications, Fibonacci measures crowd behavior and the willingness to buy or sell securities at key retracement levels. It also identifies key reversal zones and narrow price bands where trending markets should lose momentum and shift into trading ranges, topping or bottoming patterns.
Fibonacci supports a variety of profitable strategies (as outlined in Use Fibonacci to Point Out Profitable Trades), but incorrect grid placement undermines prediction and confidence. Traders get frustrated when they try the tool for the first time and it doesn't work perfectly, often abandoning it in favor of more familiar analysis. However, persistence, precision and a little formfitting can generate trading edges that last a lifetime.
Use a retracement grid to analyze pullbacks, reversals, corrections and other price actions within the ranges of primary uptrends and downtrends. Use an extension grid to measure how far uptrends or downtrends are likely to carry beyond a breakout or breakdown level. This analysis forms the basis for establishing technical price targets and profitable exit zones.
Setting Retracement Grids
It takes skill to set Fibonacci grids correctly, and picking the wrong levels as starting and ending points undermines profitability by encouraging buying or selling at prices that make no sense. The process also requires multi-trend grid placement, with successive levels placed at longer and shorter time frames until they capture price ranges that might come into play during the life of the open position.
Start grid placement by zooming out to the weekly pattern and finding the longest continuous uptrend or downtrend. Place a Fibonacci grid from low to high in an uptrend and high to low in a downtrend. Set the grid to display the .382, .50, .618 and .786 retracement levels. The first three ratios act as compression zones, where price can bounce around like a pinball, while the .786 marks a line in the sand, with violations signaling a change in trend.
Now move to shorter-term trends, adding new grids for those time frames. Once completed, your chart will show a series of grids, with lines that are tightly aligned or not aligned at all. Tight alignment identifies harmonic support and resistance levels that can end corrections and signal trend advances, higher or lower, especially when supported by moving averages, trendlines and gaps. Loose alignment points to disorganization, with conflicting forces generating whipsaws that lower predictive power and profit potential.
Delta Air Lines 60-Minute Retracement Grids
Fibonacci grids work equally well in uptrends and downtrends and in all time frames. In the chart above, Delta Air Lines, Inc. (DAL) sells off between $48 and $39 in two distinct waves. Placing a grid over the longer-term decline highlights key harmonic resistance levels, while stretching a second grid over the last sell wave uncovers hidden alignments between time frames.
The .382 retracement of the longer wave (1) narrowly aligns with the .618 retracement of the shorter wave (2) at (A), while the longer .500 retracement aligns perfectly with the shorter .786 retracement at (B). The bounce off the June low rallies into the lower alignment (A) and stalls for seven hours, yielding a final burst into the upper alignment (B), where the bounce comes to an end. (See also: Strategies for Trading Fibonacci Retracements.)
Setting Extension Grids
Extension grids work best when ratios are built from trading ranges that show clearly defined pullback and breakout levels. For an uptrend, start the extension grid from the swing low within the range and extend it to the breakout level, which also marks the high of the range. Click once to establish this grid and a second grid will appear. Start this grid at the breakout price, stretching it higher until it includes the Fib ratios likely to come into play during the life of the trade.
Reverse this process for a downtrend, starting from the swing high and extending it to the breakdown level, which also marks the low of the range. Click once to establish this grid and a second grid will appear. Start this grid at the breakdown price, stretching it lower until it includes the Fib ratios likely to come into play during the life of the trade. Downside grids are likely to use fewer ratios than upside grids because extensions can carry to infinity but not below zero.
Apple Weekly Extension Grid
Apple Inc. (AAPL) ends a historic uptrend (B) and enters a long-term trading range, bottoming out at (A). It rallies to range resistance after two years and breaks out, allowing the technician to build a weekly extension grid using the trading range low (A) and high (B). Ratios built from this 46-point swing (101 - 55 = 46) show harmonic resistance at $130 (.618), $145 (1.00) and $173 (1.618). The stock tops out a few months later, right at the .618 Fibonacci extension, and sells off to $101 to test breakout support. (For more, see: Advanced Fibonacci Applications.)
The Value of Formfitting
Cut your workload by focusing on harmonics that will come into play during the position's life, ignoring other levels. For example, it makes no sense for a day trader to worry about monthly and yearly Fib levels. However, don't assume that longer time frames don't matter, because a trade lasting a few weeks can reach harmonic levels going back five, six or ten years when already positioned close to a long-term level. These outliers can often be managed by taking a quick glance at the weekly or monthly chart before deciding which grids are needed.
Finally, go ahead and do a little formfitting if needed to align the grid more closely to charting landscape features, like gaps, highs/lows and moving averages. Move the starting point to the next most obvious high or low to see if it fits better with historical price action. In practice, this often means choosing the higher low of double bottom or lower high of a double top.
The Bottom Line
Build Fibonacci retracement and extension grids to identify hidden support and resistance levels that may come into play during the life of a position. The most dependable Fib reversal signals come when grid ratios align tightly with other technical elements, including moving averages, gaps and prior highs/lows. Build detailed entry and exit strategies with retracement grids, while using extension grids to locate price targets and realign risk management parameters. (For additional reading, check out: Top 4 Fibonacci Retracement Mistakes to Avoid.)