Did you find the Holy Grail in trading? If you know when to enter the market and when to exit the market at the right time, you have found the Holy Grail in trading. Fibonacci Retracement and Extensions is the Holy Grail for many traders. They trade by these Fibonacci Levels. Fibonacci sequence is a famous sequence that appears quite frequently in nature. Fibonacci sequence is obtained by adding the last two number to obtain the next number. The first two numbers are 0,1. After that just add the last two numbers to obtain the next number. Fibonacci sequence just develops like 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55,89,144,233,377 and so on.
Ratios obtained by dividing a number in the Fibonacci sequence with the number before it and with two numbers before it are always the same. These two numbers 1.27, 0.618 and 0.382 are very important and occur frequently in nature. These three ratios are used to construct Fibonacci Retracements and Extension Levels.
When there is a trend, price action is steadily going higher or lower. In case of an uptrend the price action makes higher highs and higher lows. While in case of a downtrend, price action makes lower lows and lower highs. This is hard to explain in words visualizing but I will make an effort. It is much better explained in front of a price chart. In case of an uptrend, price action starts from the support A, goes to resistance B, bounces back retraces itself and reaches a newer support C somewhat higher than A bounces back and reaches a higher resistance D before it again bounces back and reaches a still higher support E. So the price action can be broken into these three segments AB, BC and CD.
Now let's start and draw Fibonacci Retracements. From B when price action bounces back, it retraces the past price action and the most likely place for the new support is one of these Fibonacci levels 0.382, 0.5 or 0.618. Either the price action is bounce back close to 0.382 level or 0.5 level or 0.618 level and then move back to the new resistance. This new resistance will be higher than the previous resistance at B. This new resistance can be at 1.27 or 1.618 from B.
Now while constructing Fibonacci Retracement and Extension, we will start from price A. Calculate the price difference between A and B. Take the three ratios 0.382, 0.5 and 0.618 for this price difference and plot them on your chart. Don't worry, your trading software will do that nicely for you automatically but you need to understand the concept. Suppose the price difference between A and B is 100 pips. If the price bounces back from 0.382, we say that the retracement was 38.2%. If is bounces back from 0.5 level we say that the retracement was 50% and if it bounces back from 0.618 level, we say that the retracement was 61.8%.
After the market bounces back and takes a U turn at one of these retracement levels and rallies to the point D we say that the market has moved 27% above the original move AB or a total of 1.27%. Now if you want to become a serious trader no matter what market you trade, you should learn Fibonacci Retracement and Extension.