One of the most challenging aspects of investing is knowing when to take your losses and when to take profits. Investors have gone through many disappointments of closing a trade with break-even or a loss after they missed the take-profit targets because of greed or indecision.
For traders closing a trade may be more important than opening one. A poorly timed buy can sometimes lead to a profitable outcome when selling the position at an optimal time. The question becomes – I am now involved in a trade or an investment, but when and at what price should I take profit?
How much easier would life be to trade with better precision and more confidence in knowing when to buy or sell? The biggest hurdle involves the inability of most traders or investors to set logical or realistic goals and targets.
An often overlooked but potentially powerful technical tool that can help traders and investors with exit strategies is the Fibonacci extension. The concept is similar to the more popular and widely practiced Fibonacci retracement, which seeks to determine how far the prices will correct before resuming their underlying trend. The difference is Fibonacci extension utilizes the 100%, 138.2%, 161.8%, 200%%, 238.2%, and 261.8% levels compared to the traditional Fibonacci retracements levels of 38.2%, 50%, 61.8%, 76.4%, and 100%.
The premise behind the Fibonacci studies remains the concept of the golden ratio. The golden ratio describes the predictable patterns in the universe, including the symmetry in the leaves in a tree and the petals in a flower that grows in well-defined spirals. The ratio derives from the famous Italian mathematician (Leonardo Fibonacci), commonly known as the Fibonacci sequence.
A special relationship exists between the golden ratio and the Fibonacci number or the Fibonacci sequence. Each number is the sum of the two numbers before it (i.e., 0, 1, 1, 2, 3, 5, 8, 13, 21, etc.). The number converges toward a singular number that equals approximately 1.618. Hence, the significance of the 61.8% Fibonacci retracement as a pivotal support zone during corrections and the importance of the 161.8% Fibonacci extension as critical resistance during well-defined primary bull trends.
The Fibonacci retracements and extensions help traders and investors better identify reversal levels and upside extension targets. However, as with any technical indicator/discipline, it is most effective when accompanied by additional technical analysis tools (i.e., trendlines, technical breakout targets, pattern recognition, moving averages, etc.).
As mentioned, Fibonacci retracements help identify buy levels during pullbacks. Supports can occur at 38.2%, 50%, 61.8%, and 76.4% retracements. Fibonacci extensions can help to identify sell levels during rallies. The most commonly used Fibonacci extension levels are 138.2 and 161.8.
The general rules are as follows: A successful test of the 50%, 61.8%, or 78.6% retracement will often result in a rally toward the 161.8% Fibonacci extension after confirming a breakout above the pivot high (i.e., Nov 2021 for Nasdaq Composite and NDX and Jan 2022 for SPX, INDU, etc.). A 38.2% retracement will often falter near the 138.20% Fibonacci extension.
A brief analysis of the SPX Index (SPX) utilizing the Fibonacci retracement and extension strategies suggests the following outcome: If SPX maintains 3,491.58 (10/13/22), this implies the index has successfully tested the 50% retracement (3,505.24) from Mar 2020-Jan 2022 rally). A successful test does not necessarily mean that SPX will resume its primary uptrend. It is only after setting a higher high above the previous reaction high (4,818.62 - 1/4/22) that this signals the resumption of the uptrend. A breakout renders an SPX target of 6,145.66 (above the 4,818.62 breakout projection) and 6,441.96 (1.618% Fibonacci extension target).
SPX remains in a neutral wide trading range between 3,491.58 (10/13/22 reaction low) and 4,818.62 (1/4/22 all-time high). Failure to find support at 3,928-3,951 (3/2/23 low and 200-day ma) warns at a retest of 3,491.58 (10/13/22 reaction low). A breakdown reaffirms the continuation of the Jan 2022 cyclical bear and the next selloff to 3,195.28 (61.8% retracement) and below this 2,811.78 ( 76.4% retracement). Despite the selloff, the Jan 2022 cyclical bear is not necessarily structural if the decline retains the critical 61.8-76.4% retracements (3,195/2,812).