Fibonacci extensions also known as Fibonacci extension levels, are a reflection of a naturally recurring numerical phenomena that we find it in all types of nature; from beehives to seashells. In the late 12th century Leonardo Pisano Fibonacci discovered a mathematical sequence that began with two numbers, 0 and 1. After that he used the simple rule: add the last two numbers to get the next.
0, 1, 1, 2, 3, 5, 8, 13, 21,……….
The graphic plot to the side shows that these values are tending to a limit of 1.618. While we find this ratio common throughout our natural universe, we often see it as well in market price action. This tends to support my theory that markets do take on a living component by themselves. What is also interesting about this number is that through this ratio, mathematicians have derived other components that seem to recur in natural phenomena. This includes .618 (1.618 – 1) and .372 (1-.618).
Technical analysis using Fibonacci projection comes in three forms. Price objectives, price retracements, and market timing windows. The first is done through an Eliot / Fibonacci wave type of analysis which uses the ratios to project probable regions for the market to advance in its primary trend. The second, Fibonacci retracements predict a region that, in a correction phase, price will return to.
The last, Fibonacci market timing windows, are used to predict when a market will have a tendency to reverse course. This is my favorite of the indicators because I can use it to time when to enter a position, and also when to take profits.
Fibonacci ratios work very well with pattern recognition methods. As an example, think about them in analyzing pennant and flag formations. Various market congestion phases such as these are perfect for projecting market setups. They give easy and reliable objectives to a trader. I find Fibonacci extensions a very reliable tool that should be included an every market analysts toolbox.