By Carl Woodhouse
Fibonacci external retracements are another powerful technical analysis tool, which can be applied to the charts of financial markets to help assist traders to identify significant areas of support and resistance.
The difference between an internal and external retracement, is that the latter applies ratios that seek to identify potential support and resistance areas, for corrections or pullbacks that continue beyond the original starting point of a trend.
Internal fibonacci retracements as shown in our last section only identify potential support or resistance areas between 0.236% and 0.886% of a trend. When these internal ratios are exceeded traders will apply external ratios to the charts to identify potential turning points.
The most common External Retracements are:
Example 1: Carnival
In this chart of the U.K stock Carnival, we have identified a pullback to the dominant downtrend. The swing high which begins the trend is identified on the 9th June @2486, and the end of the trend is identified as the swing low made on 6th Aug @2085 We have applied Fibonacci internal retracements to the market, and are looking for some indication that one of the ratios will act as an area of resistance to price.
Example 1.1: Carnival
If the pullback exceeds the entire range of the internal retracements and the starting point of the trend ( @2486), this would mean that price has retraced more than 100% of the prior downtrend.
Traders will apply Fibonacci external retracements to the chart at this point, to identify new potential high probability support and resistance areas to price.
In this example, price has entered into the range of the 1.128 Fibonacci external retracement @2537.3. The ratio proved to be a significant area of resistance, pushing prices down over 350 points!!.
Fibonacci External Retracements in an Uptrend
- When applying Fibonacci External retracements to an Uptrend, the general idea is to take profits, close a short position or go long ( Buy) once price reaches one of the plotted ratios.
- Many moves tend to terminate at the 1.272 – 1.618 external retracement of prior swings
- External retracements can be a powerful and insightful tool for any trader with an open position in any market or any time frame
Example 2: Ford Motor Company
External retracements are applied to financial charts in exactly the same way we apply internal retracements. During an uptrend once the tool has been selected the trader must identify and click on a significant swing low, and drag the cursor up to the most recently identified swing high. This will plot the external retracement ratios and their corresponding price levels.
A swing high is typically identified by a recent high, with two lower highs on the left and right of the high bar.
A swing low is typified by a recent low with at least two higher lows on either side of the low bar.
Here we plotted the Fibonacci external retracement Levels on an uptrend in Ford Motor Company by clicking on the Swing Low made on the 3rd Feb 2014 @ 14.4000 and dragging the cursor to the Swing High made on the 24 Jul 2014 @18.1200. The charting software automatically plots the Fibonacci external ratios and their corresponding levels.
If the market begins to correct or pullback from this high @18.1200 and price exceeds the start of the uptrend@ 14.4000 there is a very high probability that the market will find support at one of these Fibonacci external retracement levels.
Example 2.1: Ford Motor Company
Now let’s look at what actually happened after the Swing High occurred. The market pulled back right through the entire range of internal fibonacci retracements and exceeds the start of the trend at 14.4000. The market finally finds significant support on the 15th Oct around 13.3882 the area 1.272 external retracement. The market then goes on to rise for 90 days reaching a high of 16.6200.
A trader who applies external Fibonacci retracements to the charts of financial markets would have been aware of these high probability support levels well in advance of the price actually reaching the area. If a trader is in an open position they are able to plan ahead and prepare to take partial profits or close a position if the market shows signs of a reversal.
Those traders who are on the sidelines but believe that the previous uptrend is going to reassert itself can look to external retracements for opportunities to climb on board the trend well in advance of other market participants
Fibonacci External Retracements in a Downtrend
- When applying Fibonacci External retracements to a Downtrend the general idea is to take profits, close a long position or go Short ( Sell ) once price reaches one of the plotted ratios.
- External retracements can be plotted well in advance of price reaching an area, giving you advanced knowledge of high probability support or resistance levels that may cause market reversals.
- This distinct advantage can help you, with profit taking, stop management, exiting trades and market directional bias
During a downtrend, once the tool has been selected the trader must identify and click on a significant swing high, and drag the cursor down to the most recently identified swing low. This will plot the external retracement ratios and their corresponding price levels.
Example 3: The London Stock Exchange
Here we plotted the Fibonacci internal retracement ratios and their corresponding prices on a downtrend in The London Stock Exchange, by clicking on the Swing high made on the 3rd Jul 2014 @ 2037 and dragging the cursor to the Swing low made on the 08th 2014 @1819.
If price trades through the internal retracements and reaches and exceeds the start of the downtrend@2037, we will delete the internal ratios, because they have failed to provide significant resistance to the market. We will then apply our external ratios the 1.128-1.618, and look for any evidence of significant resistance or a market reversal taking place at these levels.
Example 3.1: The London Stock Exchange
On the 27th of Aug 2014 the share price of The London Stock Exchange closes above the start of the downtrend. We will now look to identify high probability areas for a possible market reversal using our external retracement ratios
We plot the Fibonacci external retracement ratios and their corresponding prices on the chart, exactly same way we plotted the previous internal retracements. This was done by clicking on the Swing high made on the 3rd Jul 2014 @ 2037 and dragging the cursor to the Swing low made on the 08TH Aug 2014 @1819
Example 3.2 The London Stock Exchange
Let’s see how price responded to these new levels.
The market trades sideways to up for six days, before finding resistance on the 4th Sep 2014. The new swing high bar which causes the reversal had a high of 2094.1 just 2.2 pips short of the 1.272 external retracement level. The market then turns sharply as supply enters the market and gaps down 5 days later by 130 points. The market continues to trend down reaching a low of 1761, this is around a 334 point drop from the 1.272 external retracement level.
External retracements can be a powerful and insightful tool for any trader and can be applied to any market and any time frame. They can be plotted well in advance of price action reaching the identified levels, allowing traders to plot high probability profit targets for open positions and identify probable areas for future trend reversals or terminations. Those traders who only use internal retracements are at a huge disadvantage and can often get sucked into trades, in the wrong direction when price exceeds the start of a previous trend. What appears to be a new trend can very often stall, terminated or reversed at an external retracement ratio.
AGAIN! it is important to note that trading Fibonacci external retracement levels should never be used as a standalone system to enter trades, but should be part of a complete trading plan. Fibonacci external retracements, should be combined with objective trade entry, trade exit and trade management strategies along with pattern, price and time analysis before the true power of these ratios are revealed.
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