Fibonacci Extension Indicator Explained

Definition of the Fibonacci Extension Tool

The Fibonacci Extensions tool shares similarities with the Fibonacci Retracements tool, with the exception that the Fibo Extension indicator requires a third leg to complete the trace. This third leg is drawn from where the retracement tool ended. The third leg of the Extensions tool is drawn in the direction of the initial trend.

FE

The Fibonacci Extensions toolbar button is used to produce the trace of the extension levels. Click on the Fibonacci Extension button on the navigation menu toolbar. Then, click the tool on the swing high -> swing low -> retracement level (short trade), or Swing low -> swing high -> retracement level (long trade). This displays the possible extension levels. The common levels where price extends to from the retracement points are 61.8%, 100% and 161.8% extension levels.

Components of the Fibonacci Extension Indicator

The Fibonacci extension indicator is made up of the following components:

  1. Dotted trendline, which is traced when the Fibonacci extension tool is drawn at the three points.
  2. Fibonacci extension levels: These are automatically applied to the screen as the tool is snapped down to the destination point after the trace has been completed. The trader can alter the number of levels shown by using the Ctrl + I function to edit the indicator properties.

Indicator Settings

The indicator is listed on the MT4 in its own category of indicators. To attach it to the MT4 chart, click on Insert -> Fibonacci-> Extensions.

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In terms of appearance, some modifications to the look of the indicator can be made. These modifications can be either to increase or reduce the number of Fibonacci retracement levels shown on the chart, or to change the colours as well as line thickness of the individual Fibo levels to improve their visual appearance.

Usage of the Fibonacci Extension Tool in Forex Trading

The Fibonacci extension tool is purely used to pick out the possible levels to which price will get to after taking off from the retracement point as the trend resumes following profit taking from traders.

Therefore, the Fibo extension indicator is supposed to be used in tandem with its retracement counterpart. The Fibo extension tool is therefore purely a trade exit tool which is used in setting the Take Profit levels of retracement entry trades.

Since this tool is to be used with the retracement tool, the best time frame with which to work with this tool is the daily chart. It must also be mentioned that since the tool works with the retracement tool, the Stochastics oscillator must also be applied to the chart. The Stochastics oscillator is used in determining the exact retracement level at which prices will resume their initial trend move. This means that the Stochastics oscillator will also serve as the benchmark for determining the exact retracement level at which the third leg of the Fibonacci extension tool trace will be performed.

We will now show two charts that will demonstrate the use of the Fibonacci extension tool in setting the Take Profit levels. One chart is for a long trade entry while the other is for a short trade.

1) Short Trade

The short trade entry is Seen on this GBPUSD daily chart. Point 1 is the starting point of the initial trend. Point 2 represents the area at which retracement commences. The Stochastics oscillator is applied to the charts and we see that the exact retracement level where the Stochastics shows an overbought signal is the 38.2% retracement area. The Fibonacci extension tool (shown in purple trace with brown extension levels) is traced from point 1 to point 2, and then the third leg is extended to point 3.

Fibo_Exten

This displays the extension levels as follows:

  • FE 61.8% (point 4)
  • FE 100% (point 5)
  • FE 161.8% (point 7)

We can see that the price action candle that approached the target areas at point 4 and point 5 actually extended down below those points and closed below them, confirming a breakout and that price would still make a push for the 161.8% Fibo extension level. However, price did not initially reach point 7, but started to retrace upwards to the 100% Fibo extension level (point 5). The Point 5 support, having been broken initially by downward price action, now served as a resistance to this price move, and price re-commenced downside movement to terminate at point 7, which is the 161.8% Fibo extension area.

2) Long Trade

The same principles used for the short trade are also applied to the long trade in reverse. You can see the strategy article on the Fibonacci Daily strategy here.

Make sure you practice how to trade each setup on a demo account before using the indicator to trade real money. Also pay attention to risk management.

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