Trading Forex with Fibonacci (Part 4)

11/23/2015 9:00 am EST

Focus: FOREX

Huzefa Hamid

Senior Analyst,

Huzefa Hamid of The Forex Room and continues his multi-part lesson on Fibonacci with a discussion of how to trade forex using Fibonacci extensions.

This week we have covered the Fibonacci percentages starting from 23.6% to beyond 100%. We then defined a retracement and looked at how the size of a retracement can coincide with a Fibonacci level on a chart. (Read Part 1, Part 2, and Part 3.)

To recap, the list of Fibonacci levels we covered were:
61.8% (The Golden Ratio)
78.6% (Square root of The Golden Ratio)
88.6% (Square root of 0.786)
112.7% (Fourth root of 161.8%)
127.2% (Square root of 161.8%)
138.2% (Addition of 100% and 38.2%)
161.8% (1 divided by 0.618)
261.8% (Addition of 100% and 161.8%)

Fibonacci Extensions
Now, we're going to examine the move beyond the retracement, often known as an "extension," and we will measure extensions using the same Fibonacci levels.

By definition, the extension is often considered the third move, or "Wave 3" when looking at a chart. There is an initial move, a retracement, followed by an extension, as in this five-minute EUR/USD chart:

Click to Enlarge

When measuring an extension in relation to Fib levels, we measure it in proportion to the first move. In other words, we look at the size of the extension and see what that size is as a percentage of the first move (up to point 1 on the chart above).

This is not as straightforward as measuring the retracement, but with a little bit of practice, it should be easily understood. Let's take a look at the same five-minute EUR/USD chart:

Click to Enlarge

For the sake of clarity, I have removed all other Fibonacci levels and just left one level displayed to prevent the chart from being too cluttered.

In this example, the 100% level is hit. What that means is that the size of the first move is equal to the size of the extension. In practice, the size of the move up to point 1 was 154 pips, and the distance the price moved from point 2 to the end of the extension was 156 pips, i.e. a fraction over 100%.

Let's take a look at two other examples of extensions hitting different Fibonacci levels. In the following example of a daily GBP/USD chart, the price moves up to point 1, retraces to point 2, then hits the 78.6% Fib extension level before moving back down again.

Click to Enlarge

Of course, extensions can be measured to the downside as well if that is the trend, as in this four-hour AUD/USD chart:

Click to Enlarge

Here, the price moves down to point 1, retraces to point 2, and then hits the 78.6% extension level before moving back up.

As with retracements, multiple extensions can be combined on a chart, and this will be explored later in the series.

In summary:

  1. The move after the retracement is known as an "extension"
  2. An extension can be measured as a Fibonacci proportion of the first move, or wave 1
  3. Multiple extension levels can be combined on a single chart

Note: MetaTrader refers to extensions as "expansions." To measure extensions in MT4, go to "Insert > Fibonacci > Expansions." Click and drag the mouse on the screen to your desired points. Double-click anywhere on the handle line to move the start and end points using the small square handles that appear. Right-click and go to "Expansion Properties" to change the Fib levels, change colors etc.

By Huzefa Hamid, co-founder, The Forex Room

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