An Explanation of Fibonacci Extensions
- In the third section of "Liber Abaci," Fibonacci proposed a problem concerning the propagation of rabbits whose solution suggested a sequence of numbers. Each number in the sequence is the sum of the two preceding numbers: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 . . . This sequence is named the Fibonacci Sequence.
- As each number in the Fibonacci Sequence is divided by the number previous to it in the sequence, the quotients move toward an unreachable number known as phi. The bigger the numbers divided, the closer the quotient comes to phi, which is approximated as 1.618. Phi is also known by other names, among them the golden section and the divine proportion, because it can be used to describe the shapes and relationships of many natural phenomena.
- As stock market prices rise, they periodically reverse, or retrace, a percentage of their upward movement, until they find their "support level," the point at which they find some support as they descend. Prices then retrace again and move up until they find their "resistance level," the point at which they find resistance as they rise. These movements might also be referred to as "impulses" and "corrections." Historically, retracement percentages seem to abide by a pattern that supports the Fibonacci ratio.
- A Fibonacci extension is a tool that is used to analyze price movement and market momentum. An extension can help to determine price projections, as well as support and resistance levels, and it may provide information that can help determine when to take a profit or when to make a purchase. The word extension refers to the fact that it can be calculated when a stock extends beyond 100 per cent of its previous retracement.
- Look at a historical chart of a stock. Note the high price, and then the low price of a retracement, of the stock. Take the difference between these two prices and multiply it by an extension ratio, for example 1.618. Add the product to the low price. The sum is the Fibonacci extension, the point at which the stock may be expected to find its next resistance level, and where it might be wise to take a profit. Many financial software programs include a Fibonacci tool that will perform these calculations automatically once the values are inputted.
- Phi provides one of a number of ways for traders to view investment charts. Fibonacci extensions yield their most successful results when combined with the results of other technical analysis tools that confirm what the extension calculations show. Fibonacci extension calculations provide levels of comfort or discomfort, levels where traders might decide to buy or sell stocks. If many traders use the same tools, their results might actually influence the market by creating artificial support and resistance levels.
