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Fibonacci ratios are widely used to develop price targets for retracements on countertrend moves. A Fibonacci retracement will help spot support levels in an uptrend or resistance in a downtrend.
Fibonacci extensions apply the same idea to price moves that are in the direction of the primary trend. They can be useful to identify targets for price advances in an uptrend and downside targets in a downtrend.
When looking at retracements, traders generally use the 38.2% and 61.8% Fibonacci ratios. Extensions will usually be associated with the reciprocals of those two ratios, or 1.618 (1/0.618) and 2.618 (1/0.382).
How Traders Use It
The initial price move is used to find the target. This idea is shown in the example below.
In the dollar index, the price fell from $91.60 to $82.80, a move of 8.8 points. This decline was followed by a short bounce. Traders believing that prices were in a downtrend could use the up move to add their shorts. The trade had a potential reward of nearly 10% based on a price target of $77.40 for the next leg down.
This target is found by multiplying the initial move of 8.8 points by 1.618 and subtracting that value (14.2) from the previous high ($91.60–$14.20 = $77.40). Conservative traders would wait for prices to break below the previous low of $82.80 before entering a short trade.
In the example, the target acted as support and the price moved higher after it was reached. Once the price dropped below the target, however, that Fibonacci extension level became resistance. Important price levels that serve as support often become resistance at a later time on price charts, just as resistance often becomes support once it is broken.
This same general idea could be applied to upside targets and could be used to find longer-term targets by using the 2.618 ratio.
Why It Matters To Traders
Markets seem to respect Fibonacci ratios, and knowing the key levels can help traders understand the long-term trend, spot potential short-term moves against that trend, and establish price targets.
While Fibonacci ratios are often used to identify retracements, they are also very useful in finding price targets when applied as an extension to the price trend.
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