FIBONACCI TRADING
How to Use Fibonacci Trading and Chart Patterns to
Identify Potential Buy and Sell Opportunities in the
Financial Market
George Milton
Copyright © 2022 George Milton
The author reserves all rights. Except as permitted under section 107 or 108
of the 1976 United States Copyright Act, no part of this book or any part of it
may be distributed, reproduced, or stored in a retrieval system in any way or
by any means, including recording, photocopying, or other forms of
transmission, without the express written consent of the publisher.
TABLE OF CONTENTS
OTHER BOOKS BY THE AUTHOR
CHAPTER 1
UNDERSTANDING FIBONACCI TRADING
What is the Fibonacci Series?
Why Did Fibonacci Derive the Sequence?
The Golden Ratio
Other Fibonacci Levels
What is a Fibonacci Retracement?
Why is the Fibonacci Retracement So Useful?
How to Set Fibonacci Levels
Fibonacci Retracement Entry Points
How to Use Fibonacci Retracements to Enter a Trade
What is a Fibonacci Extension?
How to Use Fibonacci Extensions to Exit a Trade
Fibonacci in Forex: A Leading Indicator
So what can we learn about Fibonacci?
Fibonacci Numbers
What Ratios are we Going to Use to Trade?
Ratios and Retracements
Fibonacci on Charts
Multiple Fibonacci Lines
Fibonacci and Forex: Extensions
Trading the 88.6% Retracement
CHAPTER 2
CANDLESTICK ANALYSIS
What is a Japanese Candle?
How to Read Candlestick Patterns
Hammer/Shooting Star
Inverted Hammer
Bullish/Bearish Engulfing Candlestick
Doji
Marubozu
Three Candlestick Reversal
Candlestick Chart Analysis & Trading Tips
Final Thoughts
Frequently Asked Questions
CHAPTER 3
FIBONACCI WITH CHART PATTERNS
Fibonacci Trading Strategies
Fibonacci Levels Used in Financial Markets
Fibonacci Retracement Levels as a Trading Strategy
Use Fibonacci Extensions
Head & Shoulders Pattern
How to Enter a Trade
Exit a Trade
How to Trade Price Action with Fibonacci
How to Set Stop Loss with Fibonacci
Frequently Asked Questions
CHAPTER 4
TRADING WITH FIBONACCI LEVELS
Fibonacci Adjustments
Classic Trading with the Indicator
Buy After Upward Momentum
Sell After Downward Momentum
Fibo + Ichimoku
Fibonacci Top Trading Tips
CHAPTER 5
TRADING WITH THE TREND
Why Trend Trading Works
Why Trend Trading is so Effective
The Importance of Support and Resistance Levels
How to Identify Support and Resistance Transitions
The Last Low or the Final High for the Best Market Entry
Trade with the Trend and Get Big Winning Trades
Why You Should Trade with the Trend
How to Determine the Trend of Any Market
Determine the Strength of the Trend
Trading Breakouts
How to Identify Possible Breakout Levels
Previous Big Highs and Lows in Trend Trading
Trade with the Confirmation Trend
Wave Theory and Trend Trading
Trade the Retest of a Breakout Level
Trade Breaks with Stop-Loss Entry Orders
Elliott Waves and Trading Trends
Bouncing Off Support and Resistance
Avoid Choppy, Chaotic Market Movement with Trend Trading
Interpreting Price Trends
Short or Short Selling
Conclusion
OTHER BOOKS BY THE AUTHOR
How to Swing Trade
Price Action Trading Strategies
Volume Price Analysis
Technical Analysis for Beginners
Trendline Trading
CHAPTER 1
UNDERSTANDING FIBONACCI TRADING
T
he story begins in 13th century with an Italian mathematician named
Leonardo Fibonacci. Read on to find out how this illustrious
mathematician created one of the best Forex trading indicators!
What is the Fibonacci Series?
Fibonacci is considered the star mathematician of the Middle Ages in Europe
and was probably most famous during his lifetime for popularizing the
Hindu/Arabic number system that is widely used today: our decimal number
system, digits 0 to 9, base ten. This is intuitively easy for humans to
understand, since we are naturally born with ten fingers that we counted as
children. Before his work, Europeans used the Roman numeric letter system,
which seems cumbersome and mathematically inelegant by comparison.
Signore Fibonacci also produced another remarkable mathematical
innovation: the Fibonacci Number sequence. You noticed that if you start
with 1 and 1, you can derive a sequence of numbers where each number is
the sum of its two previous numbers. Therefore, the first numbers of the
standard Fibonacci sequence are executed as follows: 0, 1, 1, 2, 3, 5, 8, 13,
21, 34, 55, 89, 144, 233, 377, 610, 987...
Why Did Fibonacci Derive the Sequence?
I was considering solving a puzzle that asked, if we start with a single
breeding pair of rabbits, which never die, and each mating pair produces
another breeding pair (creating a spiral also known as the Fibonacci spiral),
how many rabbits will there be at the end of a year? The Fibonacci sequence
solves the problem.
That is not the end of the story. If you take a Fibonacci number within the
sequence and divide it by its next number, you get a result equal to or at least
very close to 61.8%, also known as the golden mean or golden ratio, as I
know sometimes. This is where things start to get really interesting!
Since ancient times, many mathematicians, scientists, and architects have
noted that throughout geometry and nature, proportion seems to appear again
and again. The nickname of the divine proportion was developed. As an
illustration, consider a line of squares or other equal geometric designs, each
of which is 161.8% the size of its predecessor. In the human body, it can be
observed in various cases. For example, each section of the index finger is
approximately 161.8% the size of its previous section (working from the tip
of the finger down). The ratio of the forearm to the hand is also 161.8%.
Although some commentators have pointed out that many famous works of
art that are commonly assumed to be based on this divine proportion actually
are not, it is sufficient for our purpose.
To point out that the Fibonacci sequence is seen by many as a way to take
advantage of a mathematical sequence in nature, and as such can be used by
traders to their advantage.
The Golden Ratio
This sequence, as ordinary as it sounds, has some very special properties. The
most localized aspect is something called the Golden Ratio.
Let's look at the golden ratio and how it is derived. If you choose any number
in the series and divide it by the next number, the answer will equal 0.618 or
(61.8%). For example, 89 divided by 144 equals 0.618 or you could choose
610 divided by 987. The answer will still be 0.618.
This feature will hold no matter how long the Fibonacci series continues and
the two numbers you choose. So, 61.8% is the Golden Ratio. Now at this
point, it is worth touching on what separates Fibonacci from other things that
exist in the world of Technical Analysis.
The Fibonacci series and the Golden Ratio are a natural phenomenon, not
something that has been artificially invented. Instead, it was discovered in the
world around us on a daily basis. Most readers are already aware of it, but its
meaning is often overlooked. When you use Fibonacci points on a chart, you
are not looking for something that has been designed for trading and may
work some times and not others, like an indicator. Instead, you are using
something that is inherent in natural systems like the movement of the
planets, the proportions of the human body, and most importantly for us, the
movement of prices in a market and on a chart.
An example of its inherent quality is when there is a release of economic
data. You will find that even during the time of the data release the price
movement still obeys Fibonacci points and the data releases wash out the
regular technical indicators.
Other Fibonacci Levels
Apart from 61.8%, there are other Fibonacci percentages. Well, instead of
dividing a Fibonacci number by its adjacent number, you can use numbers
that are one or two places apart. So, using 233 as an example, generate the
following Fibonacci percentages.
Taking the consecutive Fibonacci numbers:
55, 89, 144, 233, 377
You get:
55 / 233 = 23.6%.
89 / 233 = 38.2%.
144 / 233 = 61.8%.
233 / 233 = 100%.
377 / 233 = 161.8%
Above 100%, you can use the multiples from the first set of percentages 123.6%, 138.2%, etc. As shown above, 161.8% is a true Fibonacci
percentage and the inverse of 61.8%. In addition to the above percentages,
others are derived from squaring (or multiplying by itself) the golden ratio,
0.618.
This then gives you:
0.618 x 0.618 = 0.786 (78.6%).
0.786 x 0.786 = 0.886 (88.6%).
0.886 x 0.886 = 0.941 (94.1%)
Fibonacci can be applied in many ways when trading, but the two key
approaches that we will study in this section are retracements and extensions
(plus the well-known Fibonacci Sequence).
What is a Fibonacci Retracement?
To better understand what this tool does, let's break down the terms Fibonacci
and retracement. Fibonacci was an Italian mathematician who discovered a
natural number sequence. This infinite sequence is created by adding the
previous two numbers in the list to create the next number. For example, 0, 1,
1, 2, 3, 5, 8, 13, 21, and so on.
Retracement refers to how a price trend can sometimes temporarily reverse
before continuing in the direction of the trend. A retracement occurs when the
market moves in one direction and then reverses its direction. The second
movement in the opposite direction is called a pullback. This is obviously a
pretty simple concept, and something you see regularly on any chart. Let's
look at a retracement of a recent drop in the value of the GBP/USD currency
pair.
The market fell approximately 900 pips from point X to point Y. It
subsequently reversed this move by 500 pips before continuing the original
downtrend. The Pullback is the second move up from Point Y. Now let's see
if there is a correlation with the Fibonacci percentages.
When you hear the term Fibonacci Retracement, it means that the amount the
market moves in the retracement phase corresponds to one of the Fibonacci
percentages, such as 38.2% or 61.8%.
If we look at the same GBP/USD retracement, 61.8% clearly acts as an
important level that defines the size of the retracement. This implies that the
currency moved from point X to point Y and then reverted 61.8% of the
original distance.
Chart reference:
Bars per hour
Point X: 2010-04-30; 0200 EST; 1.5473.
Point Y: 2010-05-07; 0500 EST; 1.4475.
Of course, a retracement can extend beyond 100%, that is, go beyond the
length of the original move. Let's take another starting point in the same
currency. Look at the last push up highlighted by the red arrow before the
price went down to Point Y. Now, let's look at Fibonacci percentages beyond
100%. As shown on the chart, 123.6% is a clear Fibonacci level for the
retracement.
At approximately 1.5045, this Fibonacci level confirms the previous one
defined by the 61.8% retracement from point X to point Y. Here is a
combined chart:
The fact that this zone was a key Fibonacci level, even after price had
bounced off it, offered some 500 pips of trading profit.
Why is the Fibonacci Retracement So Useful?
The Fibonacci retracement tool helps traders identify levels to set buy stop
limits or sell stop limits that can trigger orders whenever a price pullback
occurs. Indicator lines also help when looking for a trade entry point level in
a trending price move.
How to Set Fibonacci Levels
Open your trading account and let's use the Fibonacci tool to analyze a chart.
EURGBP often shows volatility. It is a perfect pair to demonstrate how the
Fibonacci tool can help you set up a more profitable order before a price
pullback. In the top menu of your trading platform, set the time frame to H4
(4 hours) and display the price as a line.
Activate the Fibonacci tool. On the chart, draw a line from the beginning of a
trend to the reversal point by holding down the left mouse button until you
reach the break. Draw a line from bottom to top and the Fibonacci tool will
create possible retracement levels to use as entry points.
If a pullback occurs, how low will it go? That is where the yellow lines or
levels can help you with your forecast. The Fibonacci levels or lines
displayed offer various entry points. Assuming the trend continues, the higher
the value of the line, the higher the profit. These entry point levels can be
customized, but most traders don't mess with the defaults. So what level
should you choose for your entry point?
Fibonacci Retracement Entry Points
The Fibonacci tool shows six levels ranging from 0.0 (no retracement) to
100.0 (full reversal). Choosing the right level is ultimately your decision, but
Fibonacci levels work as an effective guideline or benchmark. Just remember
that an indicator is not a time machine and market prices do not always
follow mathematical rules.
23.6: A slight movement that occurs frequently and provides little value
or improved profitability.
38.2: An accurate forecast at this level creates attractive profits, and the
probability of its occurrence is still quite high.
50.0: It is not a difficult task by any means, but the improvement in your
profit ratio improves significantly, compared to opening a position at the
top.
61.8: Enter the realm of more and more unlikely. Catching that
investment in the middle of a rally is a long shot, but very profitable when
it happens.
More conservative traders will probably set entry levels between 23.6 and
50.0, but that number will increase as their knowledge and experience grows.
By opening an order at a retracement level, your buy order will be more
profitable if the uptrend continues. In the example above, the reversal fell to
the 38.2 mark and then continued to rise well beyond the price at the time the
Fibonacci lines were drawn.
How to Use Fibonacci Retracements to Enter a Trade
In this section, I will show you how to apply Fibonacci retracement levels to
a chart and what information it provides. Remember, indicators indicate
possible price movements and entry and exit points. You will still need to
interpret the data yourself, so I will show you how to do that too.
One of the most favored ways to trade Forex is to wait for a strong directional
move, then wait for it to retrace, and then enter when the retracement ends in
the direction of the original strong move. This is often done as a breakout
trade, with the entry placed just above the high or low (as applicable) of the
original move:
The trail of 5 consecutive bullish green candles on the right of the chart
above shows an upward movement. If the high price of the movement,
marked by the text and the arrow, is exceeded, then we have a breakout.
The run of 30 mostly red candles to the right of the chart shows a bearish
move. If the low price of the movement, marked by the text and the arrow is
exceeded, then we have a breakout.
Alternatively, a trader could instead wait for a qualified original directional
move and then use Fibonacci values to determine the points at which the
pullback is likely to turn around and resume the original move. It is
important to note that Fibonacci does not have to be the only tool used in this
strategy; it can be combined with price action, round numbers, or other
indicators that provide correct readings for confirmation.
Before looking at some examples, we must first understand how Fibonacci
retracement values are calculated. But don't worry, you won't have to
calculate them yourself, because every charting platform includes a Fibonacci
retracement tool as an indicator.
Fibonacci retracement indicators indicate horizontal values equal to a
retracement percentage of the move being measured. The values that are
usually indicated are:
50.0%: This is not a Fibonacci number by any means, but is usually
included in the sequence, the logic being that the middle of the road is an
important psychological turning point.
61.8%: The average/golden ratio. Divide any number in the sequence by
the number to its right, for example, 34/55.
78.6%: The square root of the median/golden ratio of 61.8%. Some
indicators do not include this value.
In addition, there are some indicators that include 76.4%. This is not a
Fibonacci number; it is simply 1 minus the first Fibonacci number of 23.6%.
Now let's see an example. Imagine that you see that the price of USD/JPY is
in a long-term downtrend, so you are interested in short-term selling
USD/JPY. On the hourly chart, you see a reasonably large downward move
that looks like this:
You decide that you want to sell with a limit order above the current price.
You pick up the Fibonacci retracement indicator/tool on your charting
platform, and click swing high (the other end of the move from where price is
now) and pull it down to swing low before clicking again (more close to
where the price is now). When you have drawn the Fibonacci retracement, it
will look like this:
You can now place your limit order to go short at any of the Fibonacci ratio
prices within the move down. The logic is that a pullback is likely to stop at
one of them. Which should I choose? That could depend on many factors
beyond the scope of this guide. Are any of the Fibonacci levels confluent
with an obvious price barrier, such as a round number? Not in this example.
The only thing I can make out in this chart that stands out is the 50%
retracement level at 114.43, which acted as resistance for three hours after the
price broke beneath it. For that reason, this level could be a good choice.
What is a Fibonacci Extension?
An extension of a trend is exactly what it sounds like - price moves, pulls
back and then spreads in the original direction. Therefore, the Extension is
the portion after the retracement.
How are the Fibonacci percentages of an extension measured? The size of
the original move (from point X to point Y) is measured from the end of the
retracement or the beginning of the extension. This gives you potential
targets as far as the extension could go.
In the MetaTrader, you can create the extensions by going to the menu bar at
the top: Insert> Fibonacci> Expansion (the MetaTrader obviously calls
Fibonacci Extensions Expansions).
So, looking at the chart below, you start measuring the Fibonacci levels from
point Z, the start of the extension. On this chart, the value of price is clearly
bouncing off the 88.6% Fibonacci extension level. Which means that the
price moves from point X to point Y, then goes up to point Z, and then goes
down covering 88.6% of the distance between point X and point Y before
going back up. You may need to read that last sentence a couple of times, but
it explains exactly the logic of Fibonacci extensions.
This Fibonacci extension level, at approximately 1.4245, is confirmed in
several ways. If you chose the previous high point before Point X (marked
with a blue line on the chart below) as your starting point instead of Point X,
you can see the price bounce off the 78.6% Fibonacci Extension.
Below is another confirmation: Shortly after Point X, price rose to make a
small spike (marked with a red arrow), before making its final decline to
Point Y.
Using that small spike as a starting point, the recent bottom in Cable is a
100% price extension.
And finally, here is a combined chart:
Now the lines are so close together that they can hardly be distinguished.
Fibonacci analysis pointed in advance that this level was a support area. All
the examples in this section use the Fibonacci levels that were discussed in
the previous section.
For clarity on these charts, I have removed the other Fibonacci percentages
by showing a retracement or extension. When analyzing my own charts from
scratch, I will use all of the Fibonacci points discussed in the previous section
(Part 1). I will be picking the most important high and low points, usually on
the 1 hour and 4 hour charts, and occasionally on the 15 minute charts, to find
my levels. I am particularly interested in the points where the Fibonacci
levels meet, and I am more interested in the 61.8%, 78.6% and 88.6% levels.
Depending on my point of view on the market, I can use a Fibonacci group to
place a trade or avoid the group if I need to see it bounce or break first. For
example, if I want to go long, but there is a Fibonacci group a few steps
away, I will wait until it breaks, or I will wait for a better (lower) entry to
give myself more space to maneuver around. Never trade without stops and
always keep an eye on your risk/reward ratio.
How to Use Fibonacci Extensions to Exit a Trade
The Fibonacci Extension Tool uses the same Fibonacci calculations to
produce, instead of an estimate of where a pullback move might stop, an
estimate of where an additional wave in the direction of the original move
might go or to be more precise, the maximum favorable distance that said
movement could cover.
As an example, we can use the USD/JPY short move that we have examined
in the previous section. You draw the Fibonacci Extension in the same way
that the Fibonacci Retracement drawing was described there. The tool then
produces some price targets, as shown below:
The next stage is to examine each level and decide if each of them is a good
profit target, even if it is for a partial profit. Please note that it is important in
trading not to take profit too early. Examining the chart, do we see any
confluence?
There are two numbers that stand out as we go down the chart. First of all,
the projection of 61.8%, which is the mean/golden ratio, converges with
111.50, which is a medium number. Second, below is an even better
confluence of the 78.6% extension level with 111.35, a key historical support
level for this pair that I had marked on my chart in the past.
We have not mentioned the use of Fibonacci forex figures to set the stop loss,
but of course it is possible to do so. For example, in the example above, you
could simply apply the Fibonacci extension in the other direction (away from
the low end to the high end) and use one of the extension levels shown in the
result, especially if it is confluent with a price. significant or other indicator.
Something that should be mentioned before concluding this section is that
sometimes it can be difficult to know which point to use for the start of the
Fibonacci measurement. In the example above, the swing high point is very
clear, but at other times it will be difficult to choose. Sometimes there can be
a swing high that is not the true start of the movement. In these cases, it is up
to you whether to pick up the recent technical high or low, or the price from
which the strong move up or down seems to have actually started.
Fibonacci in Forex: A Leading Indicator
Indicators like moving averages, Forex MACD, the King RSI indicator and
Stochastic indicator generally try to fit in the market. They do not necessarily
work in all market conditions and they do not have any intrinsic properties
that a market has to respect.
However, this is not true of Fibonacci. What I think makes Fibonacci
exceptional is that Fib indices are inherently part of natural systems,
including markets. Fibonacci ratios are not biased for certain market
conditions or economic cycles. And Fibonacci ratios aren't trying to fit a
certain style or market; rather they are simply a natural part of market
movements. This makes Fibonacci robust, versatile, and timeless.
One of my favorite Fibonacci plays is a retracement from the 88.6% level.
This level is derived by taking 61.8% of the golden fib ratio, square rooting
it, and square rooting it again.
A pullback consists of an initial move, a pullback of that first move, and then
the subsequent move of the pullback, like this:
Now when I say, this is a Fibonacci retracement of 88.6%, all I mean is that
the retracement is 88.6% of the size of the initial move. So if the initial move
was 100 pips up, the pullback would be 88.6 pips down. It doesn't matter if
the initial move was up or down. Here are some examples of the 88.6%
Fibonacci retracement. First, a GBP-USD 5-minute chart where the initial
move was higher followed by a retracement lower:
On a weekly level the USD/CHF pair shows a bearish trend and then a
bullish trend:
This is an excellent example of the high accuracy of Fibonacci levels. After
the initial decline, the price rose again 1,821 pips in 27 weeks and reached
the Fibonacci level at 2 pips! These types of setups can allow traders to have
single trades that yield over 1,000 pips while controlling their risk. And just
to show the versatility of the markets, this is the daily chart of the NASDAQ,
Apple (AAPL):
In this case, the stock price dropped more than $27 in four days, then pulled
back to within a few cents of the 88.6 level, before turning back down.
When I trade a Fibonacci retracement, I like for price to hit the level and
move away within a bar or two of the time frame I am using, i.e. not hang
around the level for several bars. In the three examples above, the price bar
reached the 88.6 level once, and only once. Secondly, I like to respect the
level cleanly: the price must not penetrate the level significantly, but must hit
the level precisely.
I always trade with a stop loss, and my profit target is the point at which the
retracement began, i.e. the end of the initial moves up or down. Often the
price will overshoot that target, but I am happy to take my profit at this point.
I will only trade this setup at a good risk/reward ratio, typically 1:2 or higher.
If I can't find a place to keep my stop at a reasonable distance from my target,
I will pass the trade.
So what can we learn about Fibonacci?
1. Fibonacci principles are timeless. It will not be forced to modify or
abandon the Fibonacci ideas when the markets turn.
2. Fibonacci principles can be used from the smallest to the largest time
frames.
3. Fibonacci has no bias for certain markets – you can use them on anything
on a chart, from a stock, a currency pair, a metal, or even a complex
derivative.
Fibonacci Numbers
So this is where it all starts: the Fib Numbers. Leonardo Fibonacci was a
13th-century Italian mathematician who popularized a simple sequence of
numbers that came to be known as the Fibonacci Number Sequence.
The sequence is as follows: starting with 0 and 1, each number is the sum of
the previous two numbers. So after 0 and 1, the next number is 1, followed by
2, followed by 3, then 5... you get the picture. The number sequence
continues forever, expanding to infinity:
0, 1, 1, 2, 3, 5, 8, 13, 21, 3. 4, 55, 89, 144, 233, 377, 610, 987...
These numbers have some unique properties. Let's take the first two numbers
in the sequence: 21 and 34. When you divide one by the other, you get 0.618.
If you take any two other consecutive numbers, say 144 and 233, and divide
one by the other, 144/233, you again get 0.618. No matter how far down the
sequence you go, you will always get to 0.618 when you divide one number
in the sequence by the next. This particular ratio, 0.618 (or 61.8%) is known
as the Golden Ratio.
Apart from 61.8%, there are other reasons present in the Fibonacci sequence.
The following ratio is found by taking a Fibonacci number and dividing it by
the number two places along the sequence. For example, if we choose 21, we
will divide it by 55, which is two places along the sequence. This gives 0.382
(or 38.2%). You would get 0.382 no matter what number you started with, as
long as you divided it by the number two places across. So 89 divided by 233
is again 0.382.
Continuing this idea, if you divided a Fibonacci number by a number three
places in the sequence, say 55 divided by 233, you would get a new ratio:
0.236, or 23.6%.
So far, we have discovered three common ratios in the Fibonacci number
sequence:
0.236 or 23.6%.
0.382 or 38.2%.
0.618 or 61.8%, also known as The Golden Ratio.
This is all great! It's an interesting idea, but where does it take us on our
journey as traders?
The reason this series of numbers, and their associated ratios, continue to be
discussed centuries after they became widely known is because they are
found everywhere in nature, and are found in markets today. For example, the
human body is built around these proportions:
From foot to head, the common ratios of 0.236, 0.382, and 0.618 are found in
the proportions of the human body.
The ratios of the DNA strands are also in line with the Fibonacci ratios, so
are the proportions of the Moon relative to the Earth and even the rings of
Saturn. The Greeks, more than two thousand years ago, used the golden ratio
when designing the proportions of the Parthenon, just as the Egyptians used
when calculating the size and height to build the pyramids. The flowers
usually have a precise number of Fib petals, such as the 55- and 89-petal
daisy varieties.
Since Fibonacci ratios are present from the smallest in DNA to the largest in
planetary systems, it is not surprising that these same ratios are seen in the
way prices move in the market.
Let's take a look at an example of how the price moves in harmony with the
Golden Ratio. This is a daily chart of EUR/USD.
The price moves from the important low, at point 1, to the important high at
point 2, and then retraces 61.8% of that distance, before moving again to
continue the original uptrend.
What Ratios are we Going to Use to Trade?
Aside from the three ratios discussed, there are other ratios that are used by
traders (and are also found in nature for that matter). The three most common
ratios are as follows:
0.786: the square root of the Golden Ratio.
0.886: the square root of 0.786.
1.618: the inverse of the golden ratio, that is, 1 divided by 0.618.
To sum up:
1. Fibonacci starts with a simple sequence of numbers; each number is the
sum of the previous two.
2. Dividing the consecutive numbers in the sequence, and the numbers
separated by one or two places, the common Fibonacci ratios are
obtained: 0.236, 0.382 and 0.618. 3. The latter ratio, 61.8%, is also
known as the Golden Ratio.
3. These ratios are found in nature and also in the way prices move in a
market.
Ratios and Retracements
The Fibonacci sequence of numbers can be used to discover ratios found in
nature and in the markets. The key ratios are:
23.6%.
38.2%.
61.8% (The Golden Ratio).
78.6% (The square root of the Golden Ratio).
88.6% (The square root of 0.786).
161.8% (1 divided by 0.618).
Before we go any further, let's add some other Fibonacci ratios found in the
markets:
100%.
112.7% (the fourth root of 161.8%).
127.2% (the square root of 161.8%).
138.2% (the addition of 100% and 38.2%).
200%.
261.8% (the addition of 100% and 161.8%)
Now, with a more comprehensive list of Fib ratios, let's see how they apply to
the markets.
Fibonacci on Charts
We will start with one of the most important concepts in trading: the
retracement. This is where price moves in one direction, then delays that
move before continuing in the original direction. This example of a
Euro/Dollar (EURUSD) 4-hour chart shows a pullback:
So, there are three parts: the initial move, the back move, and finally the post
move. Of course, pullbacks can also be pulled back in the other direction. For
example, on this Euro-Yen (EURJPY) 4-hour chart, the initial move is down,
and the pullback is up:
Let's start matching the Fibonacci ratios with the markets starting with the
retracements. By definition, a retrace traces a portion of the initial movement.
The length that the initial move is retraced can be measured in relation to
Fibonacci levels.
Now when I say, this is a 78.6% Fibonacci retracement, all I mean is that the
retracement is 78.6% of the length of the initial move. So, if the initial move
was 100 pips upward, the retracement would be 78.6 pips downward. Let's go
back to the same charts we looked at before, starting with the EUR/USD
chart:
Price moved up from point 1 to point 2, then retraced exactly 78.6% of that
distance to point 3, before returning to the original direction. Let's take a look
at the same EUR/JPY chart that previously showed a pullback to the upside,
this time with Fib levels in place:
Now you should get the idea: price moved down from point 1 to point 2, and
was back up 78.6% of that distance to point 3, before going back in the
original direction.
Multiple Fibonacci Lines
Can you start at different points to gauge your retracement? A retracement
can be measured at different Fibonacci levels using different starting points
for the initial move.
In the Australian Dollar (AUD/USD) chart below, the price moves down to
point 1, back to point 2, and then continues to move down in the original
direction. Several highs were recorded before the price reached point 1. I
have marked the two most recent and prominent highs as Point X and Point
Y.
When price moved from point X to point 1, it retraced 61.8% of that distance
to point 2 before continuing the downward move. This is marked by the red
horizontal line.
Now, if you chose to use Point Y as the starting point to measure the
retracement, Point 2 was a retracement of 112.7% of the distance from Point
Y to Point 1 (marked by the blue horizontal line). Therefore, a retracement
can actually go beyond the start of the initial move depending on where you
choose to start your measurement. That is why it is important that Fibonacci
levels exceed 100%.
The Australian dollar example also illustrates another point that we will
examine later. Different fib levels produce confirmation points that allow us
to plan trades.
Looking at the charts, you can find examples of small pullbacks reaching
only the 23.6% level, to larger pullbacks going all the way back to the 88.6%
of the initial move. You can examine pullbacks from smaller charts. For
example, 5 minute bars, to long term charts using weekly bars. The principles
apply in the same way. As this series of sections unfolds, we will see further
how these principles can be applied to trading scenarios to find entry points,
targets, and protect risk.
In Summary:
Fibonacci levels used in trading start from 23.6% and extend well beyond
100%.
A retracement can be measured relative to Fibonacci ratios.
Multiple Fibonacci levels on a chart can clearly show key price areas.
Many of you use the MetaTrader for your charts. In MT4 trading, the next
button is the Fibonacci Retracement tool:
1. Once pressed, click and drag it over the chart from the selected start point
to the end point.
2. Where you click first is where the 100% level will appear and where you
finish dragging is where the 0% level will be set.
3. Double click on the Fibonacci lines that appear and you can move the
ends from the little squares on the ends of the handle to fine tune your
selected points.
4. Right-click and go to Fib Properties in the pop-up menu to add levels,
change colors, etc.
5. Remember to get 0% and 100% backwards: think about what you are
measuring; if you are measuring a pullback, you need to make sure that
0% is at the start of the pullback.
Fibonacci and Forex: Extensions
The extension is often thought of as 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 EUR/USD 5-minute chart:
When an extension is measured in relation to fib levels, we measure it in
proportion to the first movement. In other words, we look at the size of the
spread 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 simple as measuring retracement, but
with a little practice, it should be easy to understand. Let's look at the same 5minute chart of the EUR/USD:
For the sake of clarity, I have removed all other Fibonacci levels and left only
one level displayed to prevent the chart from becoming too crowded.
In this example, the 100% level has been reached. Which means that the size
of the first move is equal to the size of the spread. In practice, the size of the
move 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 above 100%.
Let's look at two more examples of extensions that hit different Fibonacci
levels. In the following example of a GBP/USD daily chart, the pair moves
up to point 1, back to point 2, and then reaches the 78.6% Fib extension level
before turning back down.
Extensions can of course be both down and up, as in this 4-hour chart of
AUD/USD:
Here, the price moves down to point 1, back to point 2, and then hits the
78.6% extension level before moving back up.
As with pullbacks, multiple spreads can be combined on one chart and
this will be explored later in the series.
In Summary:
1. The movement after the pullback is known as extension.
2. An extension can be measured as a Fibonacci ratio of the first move, or as
Wave 1.
3. Multiple spread levels can be combined on a single chart.
The MetaTrader refers to extensions as expansions. To measure spreads in
MT4:
1. Go to Insert > Fibonacci > Expansions. Click and drag your mouse on the
screen to the points you want.
2. Double click anywhere on the handle line, move the start and end points
using the little square handles that appear.
3. Right click and go to Expansion Properties to change grain levels,
change colors, etc.
Trading the 88.6% Retracement
When Fibonacci is applied to trading, there are three common paths:
1. Using multiple retracements and extensions to find price levels where
different Fibonacci levels match to produce clusters.
2. Use additional indicators, for example MACD, with Fib levels.
3. Using Fibonacci levels as part of larger chart patterns, for example a
Head and Shoulders reversal pattern.
Now let's discuss one particular Fibonacci level that I focus on much more
and often trade in isolation: the 88.6% retracement.
To recap, the 88.6% level is derived by taking the Golden Ratio, 0.618,
rooting it squared, and rooting it squared again to get 0.886. Now when I say,
this is a 88.6% Fibonacci retracement, all I mean is that the retracement is
88.6% of the size of the initial move. So, if the initial move was 100 pip
upward, the retracement would be 88.6 pip downward.
Fibonacci levels do not have a bias for particular timeframes: they have same
validity whether it is a higher timeframe weekly chart or a lower timeframe
5-minute chart.
On the weekly chart, the dollar is at the center of the economic scene, and the
USD/CHF pair.
The price first reached a high at Point X at 1.1967 on March 8, 2009. It
then fell to a low at Point Y at 0.9909 on November 22, 2009.
Therefore, the price moved 2,058 pips in 37 weeks. The price then fell
back to Point-Z at 1.1730 (or 1,821 pips) on May 30, 2010, that is, 28
weeks after Point-Y. If you look closely at the chart and numbers, the
pullback was 2 pips from the 88.6% level.
This is incredible given that price has traveled thousands of pips over many
weeks and months, yet still made such an accurate hit against a key Fibonacci
level.
Identifying this level and seeing a clean hit could give a trader over 1,000
pips if they chose to lower the price after the pullback ended at Point Z. If
you were to zoom out from the chart, you will notice that this setup was part
of a very long-term downtrend for USD/CHF, which has in fact continued
into current day.
Alternatively, knowing that a Key Fib level has been successfully and cleanly
tested, a trader could take multiple trades on lower timeframe charts, such as
4-Hours or 1-Hours, looking for entries to sell USD/CHF. By entering shorter
timeframes, but using a long-term level, you can limit losses and improve the
risk/return ratio of your trades.
A potential target for your trades could be the start of the retracement, Point
Y, or a 100% extension of the initial move, which would be slightly beyond
Point Y.
Summary:
Fibonacci levels can be used on both higher timeframe and lower
timeframe charts.
Fibonacci can be traded with other chart patterns and indicators.
The 88.6% Fibonacci retracement level is particularly strong to trade in
isolation.
CHAPTER 2
CANDLESTICK ANALYSIS
A
spiring traders often overcomplicate their lives, researching complex
strategies or filling their charts with endless indicators. Good trading is
not about creating attractive charts. Some of the best traders in the world
don't have great chart reading skills.
Although there are entire books devoted to the subject, over time, most
traders will realize that there are only a few Forex candlesticks or candlestick
patterns that they can take advantage of. The dizzying variety of possible
candlestick patterns can often lead to analysis paralysis. If you can limit the
candlestick patterns you use as signals to just a few of the best patterns, you
can take trades with more confidence and avoid overtrading. Here's how to
identify these candlestick patterns.
What is a Japanese Candle?
Japanese candlesticks are a way of graphically representing price fluctuations
over time. In Western countries, traders used bar charts in much the same
way, but the Japanese candlestick became popular around the world in the
1990s as most traders found the format more informative than the old-
fashioned bar chart.
Like a bar on a price chart, each Japanese candlestick represents the
movement in prices at a point in time in history, depending on the time frame
of the price chart in which it appears. For example, on a daily price chart,
each candlestick represents one day. Each candlestick is drawn using its
opening, high, low and closing prices. The area between the open and close is
filled horizontally with a solid color and is called the real body. When the
close is higher than the open, the candle is colored with a bullish color
(usually green or blue). When the close is lower than the open, the candle is
colored bearish (usually red). If price moved higher than the highest close or
open during the period the candlestick was formed, a vertical line extends
upward from the real body of the candlestick until it reaches the highest point
at which the candlestick was formed (price quoted).
Today, candlestick charts are considered by most technical analysts to be
easier to read than bar charts and better convey the story behind price
movements.
With enough practice, you will be able to see the story told by the movement
of the last ten or twenty candles, and this will make your analysis of the most
recent one, two or three candles more powerful, because looking at the longterm history will give you the context of what is happening now, which can
be very helpful in judging whether it is the right time to enter a long or short
trade.
How to Read Candlestick Patterns
Once you have learned several important candlestick patterns, you will be
eager to try them out in your Forex trading. However, it is important to be
careful, as it is easy to try too hard to spot them and start finding them
everywhere, which can lead to over-trading. The best thing to do is to review
historical Forex price charts and look for candlestick patterns that really jump
out at you. Could they have created a profitable trade for you? When you
look at successful candlestick setups, do they have anything in common? You
may find that the best candlestick patterns were relatively large and very clear
and easy to read.
Another thing that is very important is to understand that candlestick patterns
that occur at key support and resistance levels, or extreme highs and lows, are
much more likely to produce good trades than patterns that form in between.
The Forex candlestick patterns explained below are all Forex reversal
candlestick patterns that can indicate where price is likely to make a major
turn. If you can successfully identify these trend reversals, you will have
entry points to open trades with a probability of giving a good and profitable
reward to risk ratio. These candlestick patterns can also be used as
continuation signals when they do not produce a reversal, and the price
begins to move beyond its price action in the direction of the long-term trend.
Now, let's take a look at the most important Japanese candlestick patterns in
Forex. Learn these, and you will be well on your way to understanding price
action.
Hammer/Shooting Star
Like many candlesticks, this pattern has a bullish version and a bearish
version. The bullish is called a hammer since it looks like one. The bearish is
called a shooting star.
The hammer has a long wick down, but it opens and closes at roughly the
same level. The open will bring the initial selling, but in the end, the buyers
come back and push the prices much higher and to the practically unchanged
level. This suggests that sellers have failed to keep prices down, and
exhaustion may be reaching sellers. These candles are very important at the
end of a bearish trend and can often signal a change in trend. Hammer
candles are also known as pin bars.
Inverted Hammer
The exact opposite of a hammer is a shooting star, also known as an inverted
hammer. The inverted hammer, as you might expect, is the inverse of the
hammer. Simply put, it is an inverted hammer. It forms on a pullback or
towards the bottom of a downtrend, and suggests that buyers entered the
market, but were unable to hold onto gains. However, it is a very strong
signal when the market turns around and takes out the top of that wick. It
shows that the buyers not only tried to go higher during a candle, but they
came back and pushed even harder to break through that short-term
resistance.
Notice that in the price chart below, the inverted hammer formed after a very
bearish candlestick. A couple of candles later, the market had formed a
couple more pseudo-inverted hammer formations, and then when the market
broke above the top of the weekly arrow candle, the market took off to the
upside. This shows how resilient buyers had been at that point. A stop loss is
typically placed at the bottom of the inverted hammer.
Bullish/Bearish Engulfing Candlestick
The encircling candle is simply a candle that completely engulfs the previous
one. It is also known as an outside candle, although some analysts
differentiate between engulfing candles, in which the real body engulfs the
real body of the previous candle, and outside candles. For an engulfing or
outer candlestick to form on a higher time frame, a wild and volatile session
is usually required.
This candle represents a serious fight that was finally won by the Bulls or the
Bears. It is strongest if the candlestick closes within the last 20% of the range
to demonstrate strong conviction. In other words, on a bearish engulfing
candle, you want to see it close within the lower 20% of its range. These
candlesticks usually signal that a move is coming in the direction of the
candlestick, as momentum builds.
Doji
The doji is the most common of all the candlestick patterns discussed in this
chapter. A doji is simply an indecisive candlestick. In a way, the shooting star
and the hammer are specialized forms of the simple doji, only they differ in
that they show exhaustion. A true doji is a range candle that fails to break out
in one direction or another. There are many different types of dojis, but in the
end, they all mean the same thing: indecision. If we get that indecision, it
stands to reason that once price finally makes a move beyond the doji range,
it means something. In the attached chart, you can see the doji candlestick
formed, and then a breakout in the following session signaled a move higher.
Marubozu
Marubozu means bald in Japanese. A marubozu candle is simply one that has
no closing wick. Although it may have a wick in the other direction, it has to
close at the highest or lowest point of the candlestick. The idea behind a bald
candle is that it has no hair (wick).
When you think about this candle, it makes sense that it is an important
candle, because it shows that traders were willing to push the market in one
direction and perhaps more importantly, hold on to that position as they did
not feel the need to take profits.
In the price chart below, you can see that there is a marubozu candle pointed
to by the arrow. The fact that the market closed at the bottom of the
candlestick shows that there is real momentum turning to the downside. If
you put a stop loss on the other side of the candle, the market would have to
completely change its mind to get you out of position.
While it is true that it has been cut for a while and there has certainly been an
attempt to reverse price movement, you can see that eventually the example
candle below could lead to a much larger move lower. These candles are not
very rare, but you have to pay close attention to them because they do not
happen often. This is especially true if you see a daily timeframe close like
this, or even a weekly one. It shows that many traders are very confident in
one direction.
Three Candlestick Reversal
A basic but surprisingly effective candlestick pattern is the three bar reversal,
also known as a three candlestick reversal. In a nutshell, it is a pattern
consisting of three consecutive candlesticks showing a reversal against the
prevailing price trend. They can be bullish or bearish, but the example shown
in the price chart below is a bearish reversal.
Note how the market has been in an uptrend for a while, showing multiple
bullish days in a row. Notice the three circled candlesticks, showing clear
upward momentum on day one, followed by another try on day two, and
finally a sell off on day three. When traders see that the initial candlestick has
broken down, they start selling as it shows that the momentum has reversed
from bullish to bearish. The stop loss is usually placed on the other side of
the center candle, as if it breaks above it, it will be seen that the momentum
has changed significantly against the potential pattern.
This is a candlestick pattern that is especially sensitive to support and
resistance levels, so if you can find such a pattern that is also confluent with a
key support or resistance level on a higher timeframe chart, it is more likely
to be effective.
Candlestick Chart Analysis & Trading Tips
If you are examining or trading a candlestick pattern, keep these guidelines in
mind before deciding what to do with your money, so you can make an
informed decision:
Determine if the market is trending up, trending down, or not trending at
all.
If you do get into a trade, you must be prepared to identify the point at
which a loss is taken, especially when you are trading against the trend.
Try not to anticipate that a pattern is going to be created by the trade
before the formation is complete.
Use technical indicators to complement patterns. Indicators help confirm
your opinion of the market trend.
When you put real money into trading, you don't trade what you can't
afford to lose!
Final Thoughts
There are different ways that traders can play with these Forex candlestick
patterns for trade entries or exits when they appear on a live price chart. The
most cautious method is to wait to see where the next candle closes before
taking any action. Traders who are more aggressive will place the trade as
soon as the candlestick breaks to the upside or downside, but as you saw in
the doji candlestick example above, that would have put the trader in a
whipsaw situation. By waiting for the close, the trader would have been more
confident that bullish momentum had built up.
Also keep in mind that, as with all things related to technical analysis, the
higher the time frame in which one of these candlesticks or candlestick
patterns appears, the more reliable it is.
Most of these candlestick patterns detailed above are relatively well known
and can of course be self-fulfilling prophecies as they are so well known and
visible. However, no price movement is 100% guaranteed, so don't expect
any candlestick pattern to be an absolute certainty.
Candlestick patterns can tell you where the market wants to go, or sometimes
where it doesn't want to go. Therefore, you can't be obsessed over the
candlesticks being perfect, but rather read what they are generally trying to
tell you in terms of how price is leaning towards its next move. While there
are basic patterns that can be rigidly worked with, there is a certain amount of
art to reading the charts, which can only be fully learned through practice and
experience.
Frequently Asked Questions
How are engulfing candles traded?
The default way to trade engulfing candles is to place an entry order above
the high of the engulfing candle (for bullish engulfing patterns) or below the
low of the engulfing candle (for bearish engulfing patterns). However, the
risk-reward of this type of entry will not always be appropriate. Therefore,
especially when daily, weekly or monthly engulfing patterns are triggered,
using a smaller time frame trigger (thus allowing for a tighter stop loss) can
stack the odds more firmly in your favor.
To what extent is a bullish or bearish engulfing pattern reliable?
From a purely statistical point of view, it is difficult to find any kind of
technical pattern that is much better than a currency. Bullish and bearish
engulfing patterns follow the same rule: without any additional filters (like
the ones discussed in this achapter), the chances of success are around 50%.
But the probability that a pattern will work is only part of the story.
In trading, you don't need to be right more than 50% of the time to make
money. For example, what if every time you trade a bullish or bearish
engulfing candlestick pattern, you could hit 3R? Even if you only win 50% of
the time, you will still make money. So by all means, filter out the best
engulfing patterns, but at the end of the day, it is the reward/risk ratio of your
trades that will determine your success.
What does an inside day candle mean?
The term inside day refers to a sequence of 2 daily candles in which the range
of highs and lows of the second day is completely contained within the range
of the previous day. In other words, the inside day is a form of range
contraction or consolidation. From a psychological point of view, an inside
day shows a certain degree of indecision. As with other candlestick patterns,
you should not take the inside day as a trading signal by itself. Despite
showing a pause in the market, the inside day gives no indication of future
direction. Therefore, the use of other filters is crucial when creating a trading
strategy that uses the inside day.
What is a bearish candle?
A bearish candlestick, generally speaking, is a candlestick that has
experienced a downward price movement. In other words, the closing price
of the candlestick is lower than the opening price of the candlestick. The
greater the decline in price from the open to the close, the stronger the signal.
CHAPTER 3
FIBONACCI WITH CHART PATTERNS
L
eonardo Pisano, nicknamed Fibonacci, was an Italian mathematician
born in Pisa in 1170. His father Guglielmo Bonaccio worked at a
trading post in Bugia, a Mediterranean port in northeastern Algeria. As a
young man, Fibonacci studied mathematics in Bugia, and during his
extensive travels, he learned about the benefits of the Hindu-Arabic number
system.
Fibonacci Trading Strategies
Key takeaways
In a Fibonacci sequence of numbers, after 0 and 1, each number is the
sum of the two prefixes.
In the context of trading, the numbers used in Fibonacci retracements are
not numbers in the Fibonacci sequence; instead, they are derived from
mathematical relationships between numbers in the sequence.
Fibonacci retracement levels are shown by constructing high and low
points on a chart and plotting the central Fibonacci relationships
horizontally to produce a grid. These horizontal lines are used to identify
potential price reversal points.
The Golden Ratio
Fibonacci described the numerical sequence that now bears his name. In a
Fibonacci sequence of numbers, after 0 and 1, each number is the sum of the
previous two numbers. 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377,
610 and so on, going on to Infinity. All the numbers are about 1.618 n-times
larger than the previous number.
This value 1.618 is given as Fi or the Golden Ratio. The golden ratio is often
seen secretly in the natural world, in architecture, fine art, and biology. For
example, proportion was observed in the Parthenon, in Leonardo da Vinci's
painting of the Mona Lisa, sunflowers, rose petals, mollusk shells, tree
branches, human faces, ancient Greek vessels, and even the spiral galaxies of
space. The golden ratio (1.618) has an inverse of 0.618, which is also widely
used in Fibonacci trading.
Fibonacci Levels Used in Financial Markets
In the context of trading, the numbers used in Fibonacci retracements are not
numbers in the Fibonacci sequence; instead, they are derived from
mathematical relationships between numbers in the sequence. The basis for
the golden Fibonacci ratio of 61.8% comes from dividing a number in the
Fibonacci series by the number that follows it.
For example, 89/144 = 0.6180. The ratio of 38.2% is derived by dividing a
number from the Fibonacci series by the number two on the right. For
example: 89/233 = 0.3819. The ratio of 23.6% is derived by dividing a
number from the Fibonacci series by the number three to the right. For
example: 89/377 = 0.2360.
Fibonacci retracement levels are shown by plotting high and low points on a
chart and plotting the central Fibonacci ratios of 23.6%, 38.2% and 61.8%
horizontally to produce a grid. These horizontal lines are used to identify
potential price reversal points.
The 50% level is usually included in the grid of Fibonacci levels that can be
drawn using charting software. Although the 50% level is not based on a
Fibonacci number, it is widely viewed as a potential reversal level, which is
particularly recognized in the Dow Theory and the work of WD Gann.
Fibonacci Retracement Levels as a Trading Strategy
Fibonacci retracements are often used in trend trading strategies. In this case,
traders look at a trade taking place within a trend and try to make low-risk
entries into the main trend using Fibonacci levels. Traders using this strategy
consider that there is a high probability that a price from the Fibonacci levels
will recover towards the initial trend.
For example, on the EUR/USD daily chart below, we can see that a major
recession began in May 2014 (point A). Price then settled in June (point B)
and retraced to the 38.2% Fibonacci level of the move down (point C).
In this case, the 38.2% level would be a great place to enter a short position
in order to take advantage of the continuation of the recession that started in
May. There is no doubt that many traders were looking at the 50% level and
the 61.8% level, but in this case, the market was not bullish enough to reach
those points. Instead, EUR/USD turned lower, summarizing the downtrend
move and reaching the previous low in a moderate fluid move.
The probability of a reversal increases if there is a confluence of technical
signals when the price reaches the Fibonacci level. Other popular technical
indicators used in conjunction with Fibonacci levels include candlestick
patterns, trends, volume, momentum swings, and moving averages. A higher
number of affirmative indicators in play equates to a stronger reversal signal.
Fibonacci retracement levels are used on a variety of financial instruments,
including stocks, commodities, and foreign currency exchange. They are also
used in various time periods. However, like other technical indicators, the
forecast value is proportional to the time frame used, with higher time frames
given more weight. For example, 38.2% on a weekly chart is a much more
important technical level than 38.2% on a five-minute chart.
Use Fibonacci Extensions
While Fibonacci score levels can be used to predict potential areas of support
or resistance where traders may enter the market in hopes of capturing a
reversal of an initial trend, Fibonacci extensions can complement this strategy
by setting profit targets based on Fibonacci. Fibonacci extensions are levels
that rise above the standard 100% level and can be used by traders to project
areas that leave good potential exits for their trades in the direction of the
trend. The main Fibonacci extension levels are 161.8%, 261.8% and 423.6%.
Let's look at an example here, using the same EUR/USD daily chart:
Looking at the Fibonacci extension level drawn on the EUR/USD chart
above, we can see that a potential price target for a trader short from the 38%
high outlined above below is at the 161.8% level, at 1.3195.
The Bottom Line
Fibonacci retracement levels often indicate reversal points with unclean
precision. However, it is more difficult to exchange them than to look back.
These levels are best used as a tool within a larger strategy. Ideally, this
strategy is a strategy that looks to combine a number of indicators to identify
potential reversal areas that offer low-risk, high-reward trade entries.
Fibonacci trading tools and other universal trading strategies often have the
same problems as Elliott Wave Theory, that said, many traders find success
using Fibonacci ratios and pullbacks to place trades within long-term price
trends. Fibonacci trading can be even more powerful when used in
conjunction with other technical indicators or signals.
Now, let's take a look at a real GBP/USD trade I took on this 15-minute
chart:
I saw that the price had tested the 88.6% level marked by a small blue line on
the chart (this is what my chart looked like while I was trading). However, I
didn't go right away. The price had already moved quickly and I was worried
about where I would place my stop loss. I continued to monitor the chart and
price moved in a nice consolidation pattern, or sideways triangle, marked by
the red lines:
This allowed me to enter the trade with a stop loss just above the triangle
instead of a larger stop above the 88.6% level. This gave me a better risk to
reward ratio than 1:3 for my trade. In other words, the profit target exceeded
three times the size of the stop loss.
As my profit target on this trade, I used a 100% extension of the initial move.
To recap, that means I took the size of the move from Point X to Point 1 and
measured it from Point 2. This is shown as the bottom blue line on the chart
below:
The following chart shows how the trade unfolded:
The price went down nicely and hit the profit target a few hours later. The
stop loss was just over 20 pips and the profit target was 80 pips.
In the GBP/USD example above, the 88.6% Fib retracement level was the
reason for the trade and a smaller chart pattern (a triangle pattern) helped to
lock in the entry. In this week's examples, the chart pattern itself is the reason
for the trade and the Fib level helps to find the entry point.
Head & Shoulders Pattern
The pattern consists of three lows:
1. The one in the middle is bigger than the two on each side. Therefore, the
middle peak refers to the head.
2. The left peak is the Left Shoulder and the right peak is the Right
Shoulder.
3. The connection between them is a neckline.
Chart patterns don't form as sharply, but over time you can train your eyes to
see them. This is what I saw on the following 15-minute chart of USD/JPY as
a head and shoulders pattern.
The chart below shows the US dollar against the Japanese yen, USD/JPY,
forming a bullish Head & Shoulders pattern. Below is a simplified diagram of
this chart pattern:
The left shoulder and head are highlighted by two blue circles, and the
neckline is specified by a red line. At the time I was looking at the chart, the
pattern was not complete and there was a potential Right Shoulder formation.
It is important to emphasize that the Right Shoulder was still potentially
forming: the price could continue to go down and not complete the pattern.
I don't see or trade this pattern very often, but I liked it in this case because
(a) I thought the neckline was very clear with multiple touches and (b) I had
very clearly identified the Left Shoulder and Head. Classic technical analysis
teaches that a trader should enter when the neckline is broken or when the
neckline is retested after it is broken (i.e. when it is broken but the price
moves back down to touch it as support).
However, I prefer to introduce the pattern before the neckline breaks. This is
because if the price breaks the neckline, it can still be a false breakout and hit
your stop-loss again. If instead, you enter during the Right Shoulder
formation, price may break the neckline but only return to your entry leaving
room to break even rather than take a loss.
Zooming in on a 5-minute chart, I noticed that the price bounced off the
88.6% Fib level between Low 1 and High 2:
The blue circle is the Head and Shoulders pattern. I have marked my entrance
with the little red line. My reasoning was that the price would at least go back
up to point 2 and this would allow me to move my stop-loss to breakeven. Of
course, the price could continue to drop after my entry and give me a loss
close to my initial stop-loss at Point-1. But the risk would be small compared
to entering the neckline and holding a larger stop loss. Let's see how the
trade unfolded:
Now I have marked the entire pattern of the chart with the neck, and the three
circles that highlight the left shoulder, the head and the right shoulder. My
entrance is marked with the little red line.
Price successfully broke the neckline after touching it a few more times and
then hovering around it. My early entry identified with an 88.6% Fib
retracement allowed me a much tighter stop loss of 15 pips. I took profit at 60
pips (after the first long bar to the upside) - once the price went up very
quickly, I was tired of a pullback, plus I had hedged four times my initial
risk, or a risk/reward ratio of 1 :4.
In Summary:
1. When you are looking at a chart pattern that you would like to trade, a
Fib level can help identify an entry.
2. Using Fibonacci levels often allows you to enter earlier than using the
chart pattern by itself.
3. Earlier entries, particularly on lower timeframes, give lower stop-losses
and better risk-to-reward trades.
88.6% Bounce of the Fib before a Movement of 150 Pips
To recap, the 88.6% level is derived from taking the Fibonacci Golden Ratio,
61.8% (or 0.618), rooting it, and then rooting it again. This gives you 0.886
or 88.6%.
When price retraces to a Fibonacci level, all it means is that the size of the
retracement as a percentage equals a Fibonacci percentage. For example, if
the price hits a low and then goes up 100 pips to hit a high, and then goes
down 88.6 pips before going back up in the original direction, then it has
retraced 88.6%.
When I am using other Fib retracement levels, such as 61.8% or 38.2%, I
often want to see a confluence of other factors such as a chart pattern,
previous support/resistance, etc. But with the 88.6% level, if I see the price
bounce cleanly and move away, I can often take a trade on that alone,
especially if it is in line with the trend of the higher time frame. I have found
that it is a very accurate predictor of price movement.
The previous morning (Tuesday Feb 7th), I saw a clean 88.6% retracement
on the EURUSD 1-minute chart:
The price made a low and then rose to a high between the two points marked
with an X; then it fell back 88.6% and rebounded at one point (this could also
be seen on a 5-minute chart).
Notice that after the bounce, not only did the price move back to the original
high, but it continued to rise for the rest of the day and didn't look back - over
150 pips from the original 88.6 level.
It is worth noting that the price at the 88.6% level, 1.3097, was also a
previous support and resistance area, further validating an entry. On the 5minute chart below I have marked 1.3097 with a red line and looking back on
the chart you can see previous support/resistance which I have highlighted
with gray boxes:
The previous support/resistance confluence is particularly useful because the
previous trend at 1 and 5 minutes was down, so taking a long trade went
against that short-term trend.
As the day unfolded, the uptrend stopped and developed into a range that
lasted about 35 minutes. During that range, another 88.6% retracement
occurred which presented opportunities to buy into the current uptrend or add
to previous long positions.
The other advantage that an 88.6% bounce has over the 61.8%, is that price
has to travel farther to the previous high (in this case for a long trade), so it
gives you a better risk/reward ratio for your trade.
I typically place stops just below the 88.6 level or the 100.0 level. Ask
yourself first, what is the risk/reward ratio of the trade? If your minimum
target of reaching the start of the pullback, i.e. the zero level at the fib lines
cannot be reached at decent risk/reward, then pass the trade.
The examples above are for long trades. They work the same way in reverse
with short trades. In those cases, the 100.0 Fib level is at the previous high
and the zero level is at the low, and you look for the price to rise to 88.6%
and bounce back down. Simplify your fib retracement lines to 61.8% and
88.6% (or even just 88.6%) and start looking for these bounces.
In summary
1. The 88.6% Fib retracement level is one of the most powerful Fibonacci
levels when it bounces; you can consider a trade only at that level or with
previous support/resistance (the best trades are more often in line with the
overall trend).
2. The 88.6% level gives good risk/reward trades when identified early.
Always consider the risk/reward ratio for each trade.
3. The bounces from 88.6% pullbacks often travel well beyond the previous
pullback, allowing you to trail part of your position.
Fib and Triangle Patterns: Getting 80 pips with a 25 Pips Stop Loss
We have written about the importance of a much neglected chart pattern, the
Triangle, and how it can produce accurate trades with excellent risk/reward
ratios.
Here, we are going to look at this concept related to a Fibonacci retracement
level that I love, the 88.6 Fib Percentage. To recap, the Fibonacci Golden
Ratio is 61.8%. If that percentage is squared and squared again, 0.886 is
obtained, that is, 88.6%. I often use a bounce off the 88.6% Fib level as a
trade entry. Let's dive into the topic and see an example. This is a live trade I
took on GBP/USD on a 15-minute chart. The following chart is the point
where I saw the formation of the trade:
My logic was this: The price moved from a high to a low (marked by the
100% and 0% lines) and then went back up to the 88.6% level (highlighted
by the little blue line). The price bounced off that level to the exact point. I
felt that the price would continue to drop and extend the previous downward
move beyond the 0% level.
I could have entered a short position immediately, but the closest place for a
stop was about 45 pips (above the previous high). While the profit target was
over 80 pips giving an acceptable risk/reward, I felt I could get a tighter stoploss on a consolidation. So instead I waited for a pullback or consolidation
(like a triangle) to plan the trade. The risk of waiting is to lose the trade
altogether, as the price could skyrocket and not consolidate at all.
How to Enter a Trade
When I checked the chart again, I noticed a triangle consolidation that price
had just broken out of and decided this was a good entry point. I used a stop
loss of 25 pip, which was just above the triangle. In the chart below, I have
marked only the initial high as Point X, the low as Point 1, and the 88.6%
level as Point 2 (and have removed the other Fib levels for clarity). And the
triangle pattern is marked with the red lines.
Exit a Trade
My goal was a 100% extension of Wave 1. This means you take the size of
Wave 1, i.e. from Point X to Point 1, and measure 100% of that size at Point
2. That gave me a target about 80 pips away from my entry. This was a
risk/reward ratio of more than 1:3 which I think is very acceptable.
When it hit the bullseye, it broke it by 1-2 pips before rebounding and going
through it firmly. See the following chart.
Summary:
1. A fib level can often produce a good setup, but if you don't see it fast
enough, you may lose the trade or have to accept a wide stop.
2. The triangle pattern can provide you with a tighter entry and thus a better
high risk/reward ratio.
3. In Forex, pips only make sense when you compare them to the pips you
risked!
How to Trade Price Action with Fibonacci
Let's recap the detailed examples shown above, going over the general
principles you should apply when using Fibonacci levels to trade Forex. The
Fibonacci is typically used by taking two extreme points (the high and the
low) and measuring the key Fibonacci ratios between them.
Below is an example of the three common levels and how to use them. In
these examples, all 3 charts are in an uptrend. They all retrace to a Fibonacci
level before rising back up with the trend.
The number 1 in the diagrams above is the first move up.
This is followed by number 2, which is the market pulling back to the key
Fibonacci level. It is at these key levels that Price Action traders would
look for strong Price Action and market clues to get along with the
uptrend.
The number 3 represents the market respecting the key Fibonacci levels
and reversing to the upside.
The chart below illustrates how this pattern plays out in the Forex market.
The price has been moving higher. A retracement to the downside falls at the
61% Fibonacci level. The market respects this key Fibonacci level and goes
back up completing the pattern.
The Fibonacci pattern can be used in exactly the same way when traders are
looking to sell the market. The only change is that traders are looking to go
short and are looking to pull back higher at key Fibonacci levels to up the
downtrend.
Below is an example of the Fibonacci tool being used in a downtrend. Notice
that the price stops at the 38.2% Fibonacci level before turning back down.
The Fibonacci tool can be a very powerful tool when used correctly. To
increase the chance of placing a winning trade, traders should look for price
action at key Fibonacci levels to confirm a trade.
As suggested in all new trading strategies, be sure to practice this strategy
with a demo account before considering live trading. Until you have proven
that you can use this tool and profit consistently on a demo account, do not
start trading live. If you can't make money with a demo account, you don't
stand a chance once you trade live!
How to Set Stop Loss with Fibonacci
Most traders are familiar with using Fibonacci ratios as entry and take profit
points, but few have considered placing stops with FIBS. Using
unconventional methods to set stop loss levels can have a surprisingly
encouraging effect on returns, and when you can find a method that is both
unconventional and reliable, a significant advantage can be discovered.
Placing stops with FIBS can be one such method. The purpose of a stop loss
is to limit risk.
Most traders tend to be of the opinion that a stop loss should be placed at the
point where the trade turns wrong, i.e. an adverse point which, if reached,
means the trade is likely to continue to go in the wrong direction.
Traders also tend to set stop losses very conservatively, telling themselves the
trade needs room to breathe when they place the stop one point above or
below the trigger candle or when they swing higher or down. Is this the right
attitude? That very much depends on the individual trader's risk to reward
profile and trading style.
The best trades often spend little time in negative area. This is not always
true, but if one looks at a large sample of historical trades produced by most
types of strategies, especially breakout strategies, one typically finds a
positive correlation of about 0.25 between trades that take off immediately
and trades that are ultimately winners. This has serious implications for the
traditional approach of setting stops so trades have room to breathe, as a
disproportionate number of winning trades need no room to breathe!
This means that many strategies, especially short-term breakout strategies,
produce a higher positive expectation if stops are placed tighter than the other
side of the candlestick or swing. There will be more losers, but the winners
will be bigger overall. How can these stops be tightened?
One approach is to look for obvious micro support or resistance levels in a
lower time frame. This can work extremely well, however often such a level
is not clearly identifiable, and it is impractical, under seriously pressured
input conditions, to spend a lot of time looking for one.
This is where the Fibs can come in. Mentally calculate the risk of pips from
your entry to where you would traditionally place your stop and apply that
number to a FIB calculator. You can select any of the common Fib ratios as
they all have some potency, but the 50% level tends to be the strongest.
Placing your stop two or three pips past the 50% retracement level can almost
double the size of your winning trades, while also being surprisingly
protective of many of the best.
It is recommended to review your past trades and see how your results would
have been different using the stop loss type of strategy.
There is an alternative approach that can be taken to place stops with FIBS
that is particularly suitable for long-term strategies that use wider and larger
stop losses. We can assume that there is a stop loss hunt especially during
periods of low liquidity. These hunts can and will drive price into those areas
one point above or beyond the swing high, where the herd tends to place their
stops.
Consider trying to place your stops further out of the woods, finding a widely
used FIB retracement or extension ratio that can be applied to a larger swing
that is placed not much further than your traditional stop loss placement area.
Place your stop loss a few pips to the other side of that level and you can find
better protection against hunters, at a small additional premium. If your trade
is for a large goal, it may be worth it.
Frequently Asked Questions
How is Fibonacci forex used in forex trading?
In a downtrend:
Step 1: Identify the direction of the market: downtrend.
Step 2: Place the Fibonacci retracement tool at the top and drag it to the
right, all the way to the bottom.
Step 3: Closely monitor the 3 potential resistance levels, that is, 0.236,
0.382 and 0.618.
How does the Fibonacci series work?
It is an infinite sequence of natural numbers; from 0 to 1, they are added in
pairs, so that each number equals the sum of the two numbers before it, so
that: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55… etc.
Does Fibonacci work in trading?
Traders should not rely on Fibonacci levels as mandatory support and
resistance levels. In fact, they can be psychological comfort levels, as well as
another way of looking at a chart.
What is the sequence of 3 5 8 8 13?
3, 5, 8, 8, 13, 11, 18, 14, 23, 17, 28, 20, 33, 23, 38, 26, 43, 29, 48, 32, 53, 35,
58, 38, 63, 41, 68, 44,73, 47…
How are Fibonacci levels calculated?
Fibonacci retracement levels are derived from this number chain. After the
sequence starts, dividing one number by the next gives 0.618, or 61.8%.
Dividing a number by the second number to its right, the result is 0.382 or
38.2%.
Where is the Fibonacci series used?
It has numerous applications in computer science, mathematics, and game
theory. It also appears in biological configurations, such as in the branches of
trees, in the arrangement of leaves on the stem, in the flora of the artichoke,
and in the arrangement of a cone.
CHAPTER 4
TRADING WITH FIBONACCI LEVELS
O
ne of the most well-known and popular trading instruments in Forex
are the Fibonacci levels (or lines). They appeared thanks to the famous
Italian mathematician Leonardo de Pisa, better known by his nickname
Fibonacci (son of Bonacci). He researched an endless mathematical sequence
that was later named Fibonacci after him. It looks like this: 0, 1, 1, 2, 3, 5, 8,
13, 21, 34, 55, 89, 144, etc., where each following number is the sum of the
previous two numbers. The relationships between the numbers in this
sequence turned out to be quite interesting: dividing a previous number by
the next one we get 0.618; dividing one number by the number after the next,
we get 0.382. These proportions are considered main, the supplementary ones
are 0.236 and 0.764.
Fibonacci numbers and their ratios have been noted to emerge in the world
around us: in nature, art, and music. For example, the famous golden section
represented as a rounded percentage is the division of a number like 62% and
38%. As soon as the trade appeared, the Fibonacci sequence also hit the forex
market.
Almost every trading platform includes a tool known as Fibonacci lines.
These are the following levels on the scale: 0.0, 23.6, 38.1, 50.0, 61.8, 76.4,
100.0. These values are expressed as percentages and show how much the
price has corrected after another move.
After developing his Elliott Wave theory, Ralph Nelson Elliott noted that
wave patterns refer to the Fibonacci Sequence. The Fibonacci sequence is a
series of numbers created by adding the sum of the previous two numbers to
create the next number in the sequence: 1 + 2 = 3
2+3=5
3+5=8
5 + 8 = 13
8 + 13 = 21
13 + 21 = 34
Therefore, the beginning of the sequence is 1, 2, 3, 5, 8, 13, 21, 34...
In trading, Fibonacci ratios are used more often than the Fibonacci numbers
themselves. You create these ratios by dividing one number in the sequence
by another. The most significant of these coefficients is the golden ratio,
which is obtained (or come very close to) by dividing any number in the
sequence by the number immediately preceding it. For example, 34/21 =
1.619. The actual golden ratio is 1.618.
Fibonacci ratios are used in conjunction with Elliott Waves as the possible
price levels for momentum and correction moves to begin and end. The
following are the most common Fibonacci ratios used in trading:
0.236
0.352
0.500
0.618
0.786
Use these indices to measure corrective movements. The chart below
demonstrates how these relationships help find a support level for a
corrective move before the next momentum move begins.
For momentum moves, you use those same relationships, but add a 1, 2, or 3
in front of them:
1,236
1,352
1,500
1,618
1,786
These relationships help measure impulse waves. The chart below shows how
these ratios encounter potential resistance to the end of an impulse wave.
Fibonacci Adjustments
In MetaTrader 4 and MetaTrader 5 terminals, there is a hotkey Draw
Fibonacci lines. The instrument default settings are as follows: 0.0, 23.6,
38.2, 50.0, 61.8, 100.0, 161.8, 261.8, 423.6. The 0.0% to 100.0% levels are
used as reference points for the correction, while the 100.0% to 423.6%
levels are possible reference points for further movement along with the trend
upon completion of the correction. For a better visual representation, the
color and style of the lines are customizable. After customization, the
instrument is ready to be used. Lines are applied on the desired chart with a
left mouse click. First, we establish the first point where the price movement
begins; then, holding down the left mouse key, we drag the correction levels
to the second point where the price movement ends. And then, we can start
looking for trading signals.
Classic Trading with the Indicator
Classic trading with the indicator is as follows: we place the Fib lines at the
last full price impulse of an instrument with the first point at the start of the
move and the second at the end of the local high/low. Then we wait for a
correction to the Fibonacci levels and see what level a bounce will form (the
correction will end) to enter the market at the continuation of the trend. The
most important correction levels are 38.2%, 50% and 61.8%, while others are
less important. If the correction confidently goes beyond 61.8%, the previous
momentum is unlikely to continue and is more likely to reverse.
Buy After Upward Momentum
Upon completion of an upward momentum, we apply the Fib lines on the
chart, extending from the low to the high, and watch for the correction. After
a 38.2% bounce, a long position may be open, taking the SL below the local
low. The profit is likely to be taken after a return to 0.0% with a possible
breakout and further move up.
Sell After Downward Momentum
We find a full downward momentum, apply the Fib lines from the low to the
high and wait for a correction. After a 50% bounce and the formation of the
local high in this area, we can open a short position, placing the SL beyond
the high. The profit target is a return to 0.0%, and in the event of a breakout,
a further decline.
Fibo + Ichimoku
To improve your trading, you can add some complementary instruments,
giving confirmation signals, to the Fibonacci lines. In this case, in addition to
a strong 61.8% retracement level, we also use the Ichimoku indicator with
default settings.
Buy After a Correction to 61.8% + Ichimoku
Upon completion of an upward price push, we expect a downward correction
to 61.8% Fibonacci level. An additional filter will be the coincidence of this
level with the lower edge of the Ichimoku cloud. If this additional condition
is executed, we open a buy position, placing the Stop Loss beyond the nearest
low, and the Take Profit near the upper edge of the cloud.
Sell After a Correction to 61.8% + Ichimoku
Completing a downward momentum, we drag the Fib lines from the low to
the high, we expect an upward correction to the area around 61.8%. The
confirmation signal will be the coincidence of this level with the upper edge
of the Ichimoku Cloud. If the signal is confirmed, we open a sell position,
placing the Stop Loss beyond the local high and the Take Profit at the lower
edge of the cloud.
Fibonacci levels are a very popular and useful instrument, which works
equally well on both higher and lower time frames. The Fib lines on the chart
allow the trader to see the reference points for their correction and once
completed, open positions along with the current trade. For greater efficiency,
Fibonacci levels will be supplemented with confirmation signals from
technical analysis tools (strong support/resistance levels, price patterns),
candlestick analysis (candlestick patterns) and other indicators (Ichimoku,
etc).
Fibonacci Top Trading Tips
Remember, market prices don't always line up perfectly with Fibonacci
levels. Many unexpected changes can and will affect your orders if you trade
daily. Most traders agree that the higher the time frame and the larger the
price difference, the more accurate the forecast will be.
Trading indicator tools can be compared to reviews on Amazon. You will get
better long-term results if you take more than one into account, so work hard
and use other indicators along with fundamental analysis.
CHAPTER 5
TRADING WITH THE TREND
T
rend trading begins with determining the trend. The market trend is
defined as the long-term direction of the market. But how to determine
what the trend is? You can look at a chart and see that from the left side of
the chart to the right side of the chart, the market has been moving up. Based
on this observation, it can be said that the trend is uptrend.
Why Trend Trading Works
Trend trading is one of the most popular methods for trading. It has been for
decades because it is a proven approach to making money in the markets.
Understanding why trend trading works can give you more confidence in
trend trading. Trend trading has a logic behind it that is rooted deep in human
psychology.
Be a Follower of Nature
Human beings are naturally social creatures. Part of what comes with that is
developing social structures to get along and function as a group. For the
good of the organization and to avoid chaos in the group, people naturally
tend to set up leaders (the minority) who guide the rest of the group (the
majority).
This dynamic makes its way into chart patterns as well. Financial markets
move because people are buying and selling. Buying and selling that is based
on people's ideas, beliefs and feelings. Therefore, the patterns you see on the
charts are maps of human nature. The nature of the crowd is to follow, which
is why most traders are waiting for someone to initiate a move in the market.
Then and only then do you jump on board. After the leaders (the professional
traders) make their commitment to buy or sell the market, the masses have a
tendency to follow them, further pushing the market in the direction of
professional trades and creating a trend.
Although many people do not like the idea of being followers, there is
nothing wrong with this in trading. The average retail trader simply does not
have enough financial muscle to start a trend. Large institutions often start
trends by trading huge volumes, taking positions, and continuing to add to
them. That creates momentum that can start a sustainable trend.
Jumping into an established trend in this way can be a great way to trade,
because there is a high probability that the large commitment of earnings
made in a given direction will create momentum for the market to keep
moving in that direction for the long term. You want to join this trend as soon
as possible because a trend can end at any time.
Why Trend Trading is so Effective
Trend trading is a popular and long-standing trading strategy for good reason:
it works! The following are some reasons why, so you don't have to blindly
accept the premise and also because understanding why can give you the
confidence mindset required for trading success.
The whales control the market. Markets are based on price in an auction
model of bids and asks and buyers and sellers, so logically the big fish in
the sea (the market participants with the big money - the pension plans,
funds investment firms, banks, hedge funds, insurance companies, and
other institutions) create the big moves in the market. This is not implying
that they are doing anything illegally, it is simply a matter of large
amounts of money invested in the markets causing them to move. If a
market participant has a lot of money, he may be able to move the market
on his own. As a group, the big money players have more market moving
power. Trend trading (also known as trend following) is one of the easiest
and most reliable ways to make money in the markets because you are
following the leaders (sometimes called the smart money).
Trend trading is one of the simplest trading strategies. The world of
trading has become increasingly complex, causing many traders to suffer
from information overload. From myriad trading systems, indicators,
automated trading software, and trading theories (with more being created
every day), new traders often feel the need to study everything available.
As a result, they become overwhelmed and confused. Trend trading is a
simple method for the markets that doesn't require a lot of fancy
technicality or a deep understanding of math, geometry, or market theory.
As a result, trend trading is one of the simplest trading strategies.
Trend trading has stood the test of time. Trend trading documentation
dates back to the 19th and 20th centuries, and is still popular today. One
of the most famous trading experiments ever done, bringing together a
group of students with no trading experience in an attempt to turn them
into successful traders (the turtle traders), was used with a trend following
strategy.
The Importance of Support and Resistance Levels
Support and resistance levels are simply prices that people who trade the
market believe the market is not likely to pass through easily. Support levels
are the prices that traders feel the market is unlikely to go next. Resistance
levels are the prices that traders feel the market is unlikely to go above.
What makes these levels work? The answer is quite simple. The market is an
auction place, and the price moves based on the mass beliefs that people who
trade in the market put into action.
Traders know and therefore see various types of support and resistance.
Crowd psychology comes into play, and most people see the market
approaching a known support or resistance level. Thus, they look to either
exit their current position at that level or enter a new position as the market
bounces off that level. Traders use these levels as follows:
Support:
Buy at a support level.
Take profit at a support level if you have gone short.
Resistance:
Short at resistance level.
Take profits at a resistance level if you have gone long.
These levels are drawn as lines on the chart. However, every advanced trader
knows that those lines aren't really lines – they are zones! Don't expect the
market to go up or down and stop exactly at a support or resistance line and
bounce off it. The market is not so clean and tidy.
In fact, the market is pretty darn dirty. So be realistic and understand that
price bars do not normally make a high or low precisely at the support or
resistance line. Most of the time, the bars go a bit past them or stop a bit
before them.
How to Identify Support and Resistance Transitions
The given range transition in order to trend is relatively easy to identify
visually and is the easiest to turn profitable. To find the transition, you must
be familiar with the concept of support and resistance. You will see support
and resistance used in many contexts. For example, they are used to identify a
trading range. They are also used to help identify when a trend has come to
an end.
For an example of how support and resistance levels are displayed on a chart,
see TWX trapped in a trading range. The support line shown on the chart is at
approximately $13.50, while the resistance line is shown near $16:50.
Support is always the lower range trade boundary while Resistance is always
the upper range trade limit. When technical analysts talk about support, they
mean the price that buyers are willing to buy enough of a stock to stop the
price from falling.
Put it another way, when sellers see enough buying interest at the support
price, they may still be willing to sell, but for now, they will only sell if they
can convince buyers to raise their offers. Buyers are now willing to buy, so
they are willing to bid a little more to complete the trade. The result is that
prices end their decline and start heading higher.
The opposite is true as the stock price is approaching the resistance level.
Buyers start to lose interest as the stock reaches high prices. Eager sellers
must lower their bid (asking) price to complete the trade, which causes prices
to stop rising and start falling.
Support levels and resistance levels are often determined visually by means
of a chart. Knowing the exact price where support and resistance lines should
be drawn is difficult, and traders may differ on where to draw these lines.
Some opt for the extreme, plotting intraday highs and lows of a trading range
over a specific time period to establish those levels.
You can use the closing prices on a daily or weekly bar chart to define the
upper and lower limits within the trading range. If you are going to analyze
an intraday chart, use the last trading price on each bar in drawing support
and resistance levels. In our opinion, closing prices (or latest prices) matter
more and better represent the consensus of traders and investors. Ultimately,
the choice is yours.
Technical analysis is not an exact science. And as such, thinking of support
and resistance levels as support areas or resistance zones is probably better
than viewing them in terms of specific prices or individual lines on a chart,
even though that is how they appear.
The Last Low or the Final High for the Best Market Entry
Even people with no knowledge of trading or investing have probably heard
the phrase buy low, sell high. The key to profitably timing the market is to
buy a low number of cycles in an uptrend or short a cycle high in a
downtrend.
The problem is how to determine, with high probability, that you are entering
the trailing cycle high or the trailing cycle low so that the market doesn't turn
around and stops out.
Although nothing can really predict the future of the market, before the
market shuts down from highs and lows, the market often slows before
coming to disengage. It's called momentum change. In this way, momentum
often drives price. This can be seen in momentum indicators going down
while price is still moving up, or conversely, momentum indicators showing
up while price is still moving down. In this way, the stochastic indicator can
often help you find the trailing high or low with extreme high probability.
Ultimate Low: When trying to trade an uptrend, you want to buy a low
number of cycles, but you want to get the lowest low before the market
continues its move up, after a retracement (trade) against the trend. To do this
with high probability, look for a change in momentum on the stochastic
indicator - a divergence between price and K%.
Trailing High: When trying to trade a downtrend, you want a short cycle
high, but you want to get the highest high before the market continues its
move down, after a retracement against the trend. trend. To do this with high
probability, look for a change in momentum on the stochastic indicator. You
see a higher high in price but a lower high in K%.
Not every low or high cycle has such a divergence pattern on the stochastic
indicator, but when you do see them, know that they are high probability
signals. This alone does not make a great trade. Cycles that give unique
information about the calendar. They don't give you information about the
direction (trend does, of course) or how far they expect a move to go after
moving up.
Trade with the Trend and Get Big Winning Trades
One of the most important advantages of trading in the direction of the trend
is that if done correctly, your winning trades are much larger than your losing
trades. This advantage is indicated to the right in the definition of the word
trend - to spread in a general direction.
The terms broaden and general direction reveal that trends are long-term
shifts. When you trade the market trends, you are making money on the longlasting movements of the market and therefore, making big profits.
The potential for huge profits in trend trading is due to the price structure of a
trend itself. The market tends to make larger moves (covering more of the
price range) and spend more time in the direction of the trend than it does
during counter-trend correction phases.
Making a lot of money on your winning trades has clear psychological value.
It's fun and encourages you to make a lot of money on every trade - the more
the better! It also has a mathematical value: when your winning trades are
larger than your losing trades, you can have as many losing trades as you win
the trade and still make a net profit.
Having some losing trades is inevitable. Sometimes you are even going to
have a major series of losing trades (such events are called Drawdowns in the
trading community). Losing trades are normal and expected.
The important factor in being able to successfully overcome these natural
drawdowns is to keep your losing trades smaller than your winning trades.
Trend trading, by its very nature, is designed to help you do just that.
Why You Should Trade with the Trend
The rationale for trend trading is if the market is already moving up, that
gives you at least some evidence of its uptrend so it makes sense to follow
that. For this reason, trend trading is also called trend following, because
instead of guessing which way the market is going to move, it waits for a
direction to be established. After it's clear, you just need to jump on board
and follow the trend that has already started.
Trends Make Life Easier
Newton's first law of motion states that an object in motion tends to stay in
motion. You can of course argue that such a law of physics does not apply
directly to financial markets. However, when large financial institutions
managing huge amounts of money commit to a market, that market will in
fact often continue in that direction.
Such institutions are not capable of bringing all of their financial power into
one market at once without altering the price structure of that market. In other
words, if they were to use all their buying power at once, it would create
demand against such an imbalance in supply that the market price would
skyrocket.
The institution would have to pay exponentially higher prices as ASKs
evaporated and bids advanced in an almost parabolic fashion. Everyone
wants to buy at as low a price as possible, for institutions to leg into a
position bit by bit over time, in an effort to hide their intentions and keep the
prices they have to pay to bring the market down.
The best time to enter a trend is as early in the trend as possible. The famous
saying, the trend is your friend is countered by, the trend is your friend to the
end.
One of the easiest chart patterns to recognize is identifying a trend. You can
clearly look at a chart and see if the market is moving up or down. Unlike
more sophisticated and complicated chart patterns, a trending market is the
easiest pattern to spot.
Trend trading is also simple for traders. Assuming you have correctly
identified a long-lasting trend, there is not much you can do after you have
entered the trade. Trends are long lasting swings, so the best thing you can do
as a trend trader is to hold tight and enjoy the ride. No need to micromanage
trading.
Trends that can Make more Money
Trend trading is a good trading style, not only because of its simplicity but
also because of its profitability.
To assess the effectiveness of your trading, measure the following ratios:
Win-loss ratio: The total number of your winning trades divided by the
total number of your losing trades.
Risk/Reward Ratio: The amount of money you initially risk on a trade
(from your entry to stop loss) versus the amount of money you win on a
trade.
You want to make more money on your winning trades than the amount you
lose on your failed trades. When you are winning trades, you make a lot more
money than your losing trades, it makes losing trades a lot easier to manage.
Because trends are long-lasting swings, the rewards of successful trend
trading are far greater than the amount of risk you take in trading. This is
good for you, both financially and psychologically.
Negotiation psychology is a vital aspect of being successful. Losses can be
difficult to take and can create a distressing emotional state in which it is
difficult for you to trade with a clear mind. On the other hand, the perfect
trading method does not exist, so all trading methods experience losses. How
you handle those losses mentally is a vital part of determining if you will
survive and thrive as a profitable trader. The chart below illustrates an
example of the small risk compared to the potentially large reward of a
successful trend trade.
Identifying the Trend
Trend trading begins with determining the trend. The market trend is defined
as the long-term direction of the market. But how to determine what the trend
is? You can look at a chart and see that from the left side of the chart to the
right side of the chart, the market has been moving up. Based on this
observation, it can be said that the trend is trending up.
On the other hand, if you look at that same market but change the point of the
beginning chart to include more history, as illustrated in the chart below, you
can tell that the market is actually in a downtrend.
Looking at the direction of the market on these two charts illustrates two
points:
Trends are always relative to the chart's scale. There is no such thing as a
market trend.
Trend determination can be highly subjective. A trending tool is needed
so that you can identify a trend from an objective measurement, not a
subjective personal assessment.
How to Determine the Trend of Any Market
Trend trading has been a very popular approach to making money in the
markets for as long as trading has been documented. Even those who do not
consider themselves primarily trend traders often consider the trend as part of
their market analysis. With so many people looking at market trends, the
question, exactly how do you determine and measure the trend of a given
market? It arises naturally. You can choose from three basic approaches:
discretionary analysis, higher highs and lower lows, and the 50-period simple
moving average.
Discretionary Analysis
Discretionary analysis involves eye-balling a chart and subjectively
determining whether the market looks like it is moving up or down. The
general direction of a market may seem obvious at a glance and does not
require excessive analysis.
The problem with this approach is that without an objective method of
measuring the trend, it is impossible to build a rules-based trading
methodology around it, which has the ripple effect of making your entire
trading methodology subjective. Unless your trading method is objective, you
won't be able to accurately time test it to determine if it is a viable method.
Highest and Lowest Highs
A very popular approach to defining an uptrend is a stock chart price pattern
that exhibits higher highs and lower lows. In contrast, a downtrend is
identified by a price pattern that shows lower highs and lower lows.
This definition has the disadvantage of not correctly defining the word trend,
which is a long-term movement. To support this, traditional technical
analysis identifies a complex retracement pattern that could be a short-term
lower swing high and swing low as a short-term correction against a longerterm uptrend.
The 50 Period Simple Moving Average
Moving averages of various lengths have been employed as trend following
indicators. New traders often like to use short-term moving averages because
they track prices more closely. They may have their uses, but because the
trend is the long-term direction of the market, a short-term moving average is
not appropriate to measure the trend.
The 50-period moving average and the 200-period moving average are two of
the most widely used moving averages. As a result, they have the advantage
of providing a self-fulfilling prophecy. Mass numbers of market participants
looking at those moving averages results in massive numbers of people
responding to them.
Consider including these two moving averages on all your charts, but the 200
moving average may be too slow of a trend indicator for your liking. It can be
used for support and resistance levels, but you may want to rely on the 50
moving average to gauge the trend.
Determine the Strength of the Trend
After determining the direction, you want to trade, you then watch the
momentum indicator to see if the momentum (force) is behind the trend. The
trend, as shown by the 50 moving average, tells you only the direction of the
market at this snapshot in time. It is not said whether the trend is strong or
weak.
If a trade is executed in the direction of a weak trend, that trend will likely
end right after entering. Momentum energy helps determine if the trend is
strong or weak, and you want to trade only in the direction of a strong trend.
The chart illustrates how to determine if a trend is strong. When entering a
cycle low in an uptrend, make sure the momentum indicator (the MACD line)
is above the 0 line on the cycle low. When you see that on the chart, you can
consider it to be a strong trend, which will probably go ahead and make a
higher high after entering.
Trading Breakouts
A breakout refers to a price movement that goes beyond, or breaks out of
recent established trading ranges or price patterns captured with trend lines.
Breakouts can occur on all time frames, from weeks and days down to hours
and minutes. The longer the timeframe, the more significant the breakout is in
terms of the overall expected price movement that follows.
In the very short term, prices on a 15-minute chart can range 20-30 pips over
several hours, for example. A breakout on such a short time scale could lead
to a 30- to 50-pip move in a matter of minutes/hours. 300- to 400-pip daily
trading ranges may see a breakout result in an initial 50- to 150-pip move in
later hours, with more to come in following sessions.
There is no real fixed ratio or scale for range breakouts; these examples give
an idea of the relative scales involved. To be sure, a breakout of a 15-minute
range can lead to a breakout of an hourly range, which can lead to a breakout
of a daily range.
Breakouts are important because they represent a change in market thinking.
Most trading theories begin with the premise that the current price reflects all
known information in that market at this time. But instead of settling on one
price and stopping, markets tend to consolidate into a price zone, or range,
where relatively minor price fluctuations are just noise in terms of the grand
theories of market price behavior.
If a range breaks, then something must have changed in the market's thinking.
And there is only one thing that will change the thinking of the market: new
information. The new information can be anything from news and data to
rumors or commentary, at the same prices.
Many traders rely on pricing information as their main source of information
for decision making. If USD/CHF prices have been covered by 1.0500 for the
past four weeks, a price move above that level is new information and
requires market adjustments.
The beauty of breakouts from an individual trader's perspective is that they
don't necessarily have to know the reason for the breakout – just that prices
have broken out. Of course, being aware of what is going on and what news
is driving the market always helps give you a head start in anticipating and
preparing for potential breakouts.
In terms of entering a position, breakouts often represent important signals to
enter or exit positions. In that sense, they take a lot of the guesswork out of
deciding where to enter or exit a position.
How to Identify Possible Breakout Levels
The first step in negotiating a breakout is identifying where breakouts are
likely to occur. Identifying breakout levels is probably most easily done by
drawing trend lines that capture recent high/low price ranges.
In many cases, these ranges will form a sideways or horizontal price range,
where sellers have repeatedly broken out at the same level to the upside and
buyers have regularly stepped in at the lower level. Horizontal ranges are
mostly neutral in predicting which direction the breakout will occur.
Other ranges will form price patterns with sloping trend lines at the top and
bottom, such as flags, pennants, wedges, and triangles. These patterns have
more predictive power for the direction of the eventual breakout and even the
distance of the breakout.
The time frame that you are looking at will determine the overall meaning of
the breakout and will go a long way in determining whether to make a trade
based on it. Very short timeframes (less than an hour) are going to be of
much less importance than a breakout of a four-hour series or a daily price
pattern.
The length of time a price range or pattern has endured also gives you an idea
of its importance. A break out of a range that has formed over the last 48
hours is going to be of less importance to price movements than a break out
of a range that has held over the last three weeks.
Previous Big Highs and Lows in Trend Trading
Previous big highs and lows are one of the most common and reliable
support/resistance levels. They work because they are visible without the
traders having to use any particular indicator. They are obvious to everyone
looking at a price chart. Support and resistance levels work because the
masses of people who trade the market respond to them.
A previous higher price high or low is simply one that stands out so
prominently on a chart that almost everyone looking at it sees it as a
significant high or low. There is no objective method for identifying it.
The fact that the masses of traders see the big ups and downs makes it
significant. When the market approaches price levels, traders see that the
market was unable to go higher or lower than the level and are concerned that
such levels represent prices that are too high/low for other traders who are
interested.
The chart below shows how the market can approach a clearly visible
previous high and find resistance. Traders will often sell at such a level
because they realize previous market participants felt that price level was too
high and therefore again may be unsustainable. The previous high can
provide long-term or short-term resistance.
Trade with the Confirmation Trend
It is often said that trend trading is late to the party, because the trend is a
lagging indicator. This statement certainly has some truth to it. Hobbyists
often hear the term lag indicator and hill running as if it were an obscene
term. The bottom line is this: Followers Indicators are lagging because they
take longer to provide a signal. During that time, they are accumulating data
that they will (eventually) use to give a signal. Because they calculate more
information before giving a signal, they tend to be more accurate than the socalled leading indicators, which often give signals based on less crunch data
(and therefore are less accurate).
No indicator can predict the future with certainty. Some indicators signal a
turn in the market at times before the price patterns indicate a turn in the
market (that's why they are called leading indicators). These leading
indicators are not always accurate, especially when used without other
confirming factors.
An indicator that can lead an impulse. It is very difficult to determine where a
market will top out before falling significantly or bottom out before rising
significantly. In other words, it is quite a challenge to call out where exactly a
downtrend or high will end and a new trend in the opposite direction will
begin.
Using a lagging indicator (either an actual indicator math formula or a price
pattern) provides more information that you can use to determine a trend
reversal. It provides you with a confirmation of the change rather than just
trying to guess which high will be the final high in an uptrend.
The chart below shows a stop in an uptrend. Do you think this is the final
peak before the trend reverses? How would you know?
As you may have guessed, the high was not the definitive high in the uptrend,
as you can see by looking further on the same chart:
Wave Theory and Trend Trading
On a chart, you see the price pattern of a stock, commodity, or currency make
some short-term moves against long-term trend shifts. This oscillating pattern
is similar to the human experience of moving toward a long-term goal, but
along the way, people often refer to taking three steps forward and two steps
back.
A typical illustration of this oscillating trend pattern is shown in the chart.
The broad general direction of the market is up, but short-term moves do
occur against the trend.
These fluctuations in trend occur because people who trade the markets
fluctuate in their optimism and pessimism based on the experience of two
primary emotions traders: fear and greed. Traders often buy into a market
because they are optimistic and have a degree of confidence that they are
going to make money.
The more the market moves in their favor, the more fear and greed creep into
their minds - fear that the market will turn against them and they will lose
their money, and greed in relation to money. They have already done and
now want to take off the market and put in their pocket.
Many traders will sell all or part of their position after the market moves
up for a while. They want to lock in part of their profits and reduce their risk
by reducing the amount of money they have exposed in case the market turns
against them. Other traders feel, for a variety of reasons, that it is time for the
market to go down. When they see the market breaking out of its doldrums
because the people who bought the market are selling, they take this
opportunity to short the market, adding more volume to the downside and
pushing the market down against the trend.
Shorting the market refers to the practice of selling before buying. Instead of
buying low and selling high, the order is reversed. For example, if you think
the market is going down, you can first sell at a high price and then buy the
position back later at a low price.
You will still buy low and sell high, but in reverse order! This may seem
strange, but it is common practice. In the stock market, you borrow stock
through your broker (and usually pay a fee to do so) and also post margin
(collateral).
After the market moves a bit, traders who are still convinced that the market
is in a long-term uptrend are going to come back and buy because they are
going to get a lower price. This can cause the short-term move down (called a
correction) to stop and the market to start moving up again with a new
momentum move. Corrections are price moves against the trend; momentum
moves are moves in the direction of the trend.
This is a simplification of what causes swings in price action as markets
trend. The following chart provides a visual reference for the impulse and
correction movements.
Trade the Retest of a Breakout Level
One way to trade is a breakout after the breakout has occurred. They may not
have realized the importance of a particular technical level, or they may not
have left overnight orders to exploit a break. You turn on your computer the
next morning to find that prices have risen higher overnight and you feel like
you have missed the boat.
But you may still get a chance to trade the breakout if prices come back to
retest the breakout level. A retest occurs when prices reverse direction
following a break and return to the breakout level to see if it holds. In the
event of a breakout to the upside, for example, after the initial wave of
buying has run its course, prices can stop and trigger a very short-term profittaking sell. The trend is for prices to return to the breakout level, which
should now act as support and attract buying interest.
You can use these retests to establish a position in the direction of the
breakout, in this case getting plenty of time on the retracement. The chart
shows where you could have bought on the retest of the higher break in
AUD/USD.
Note that prices do not exactly make it back to the breakout level. When it
comes to entering a retest, you may want to consider allowing a margin of
error in case the exact level is not retested. You might also consider using an
averaging strategy in a position to establish a position on any comeback
pressure after a breakout. Here the average range would be between current
prices and the breakout level.
You may have the opportunity to buy and sell a retest of a breakout level.
The reason is that not every breakout expects prices to retest the breakout
level. Some retests may retrace only part of the breakout move, without
actually retesting the exact penetration level, which is usually a good sign
that the breakout is real and going to continue. Other shoots never look back
and just move on.
But to the extent that this is a common enough phenomenon, you still have to
be aware and anticipate that prices may return to the breakout level. From a
technical point of view, if prices do retest the breakout level, and the level
holds, that is a strong sign that the breakout is valid, because market interest
is entering there in the direction of the breaking off.
Trade Breaks with Stop-Loss Entry Orders
After you have identified a likely breakout point, you can use a resting stoploss entry order placed just beyond the breakout level to get into a position if
a breakout occurs. To go long for a break to the upside, you would set a stoploss entry order to buy at a price just above the upper level of the range or
pattern.
To go short of a break lower, you would set a stop-loss entry order to sell at a
price just below the lower level of the range or pattern. The figure is a chart
showing the EUR/USD and where stop-loss entry orders could be placed to
trade breakouts.
The appeal of using stop-loss entry orders is that you are able to trade the
breakout without any further action on your part. Breakups can happen in the
blink of an eye. Just when you thought the upper range level was going to
hold and prices started to drift, for example, they are going to make a big
rally and blow through the breakout level.
Price moves like that can leave more experienced traders caught like deer in
headlights. By the time they react, the breakout has already seen prices jump
past their desired entry level. Worse yet, by trying to trade the market on a
fast-moving breakout, you may lose your price and have to re-enter the trade,
at which time prices may have moved even further in the direction of the
downside breaking off.
When placing a stop-loss entry order to trade a breakout level, be aware of
any major data or news events that are emerging. If your stop-loss entry order
is triggered as a result of a news event, the fill rate of the order could be
subject to slippage, which can reduce much of the profit from riding the
breakout.
Elliott Waves and Trading Trends
The term waves are most often associated with Elliott waves. Ralph Nelson
Elliott developed the Elliott Wave Theory. Elliott wave theory's rules can be
very detailed and its application can be very complicated. The market's waves
are created by the masses of traders' alternating optimism and pessimism. The
traditional Elliott Wave theory states that every trend has five waves: three
impulse moves and two corrective moves. Each momentum movement has
unique characteristics with respect to the actions of market participants.
The first momentum move is hard to spot until after it is over. Prior to this
momentum move, the market had been trending in the opposite direction, and
for that reason, sentiment is still generally bearish (assuming the market is
starting a new wave of an uptrend).
The second push move is normally the longest of the three push moves. As it
starts to pick up steam, confidence starts to change, and eventually the
masses start to get on board (usually after the market breaks the high of the
previous momentum move).
The third and final momentum move is marked by very positive sentiment
among traders. It is during this third edge that many retail traders buy into the
uptrend because it is so clear now. However, like many things in commerce,
by the time everything is obvious to all, you are late to the party. This move
is usually of shorter duration and price level than the second momentum
move. Elliott waves take the general information about the psychology of
wave masses and apply stricter and more specific rules. Here are three hard
and fast rules that determine which impulse and corrective waves are waves
1, 2, 3, 4, and 5:
Wave 2 cannot move past the start of wave 1.
Wave 3 cannot be the shortest of the three momentum moves.
Wave 4 cannot go beyond the end of wave 1.
Bouncing Off Support and Resistance
Some traders prefer to buy and sell lags in the trend. Some traders prefer to
enter trades on breakouts, entering the market after price breaks above a
previous high (or below a previous low, if going short).
Going into delays or breakouts are both valid trading techniques. The concept
of trading a breakout is to wait for the market to make a commitment with the
upside moving above a previous high.
When you trade the pullbacks, you enter at a lower price and the initial risk
on the trade is smaller than the initial risk break traders generally have.
Breakout traders often criticize retracement traders saying that they are
trading while the market is going against the trend, and therefore it is riskier
than their approach. They deny that no one knows how low the pullback will
go, or even if the market continues in the direction of the trend. Therefore,
they believe that trading only when the market has shown that it will continue
in the direction of an uptrend, making a higher high, is more conservative and
reliable.
That argument has some merit. But just because the market makes a higher
high does not guarantee that it will continue to move higher after you enter
the trade. Anyone who has changed for a long period of time can tell many,
many sad stories of false breakouts. The chart illustrates a retracement to a
Fibonacci level after which the market moves up in the direction of the trend.
Avoid Choppy, Chaotic Market Movement with Trend Trading
Amateur traders often complain that they make a little money trading and
then soon give it all back (and sometimes give back more than they make).
This see-saw effect of making money and losing money over and over is
common for many traders because, for example, markets don't always trend
in a clear up or down direction.
Markets typically spend long periods of time making hectic chaotic price
movements, which occur when market participants do not have a consensus
among themselves as to whether a given market is undervalued or
overvalued, or whether it is a big opportunity or a bad one.
On such occasions, the market does not present any kind of predictable
pattern. It's just spinning around randomly and with no clear direction up or
down. It can be characterized by high volatility or low volatility (range-wide
price moves or price-lower range moves), but the characteristic definition is a
lack of clear, long-term direction up or down.
Some people believe that markets are inherently unpredictable and somewhat
spontaneous. Extreme adherents claim that all information that is publicly
known is already priced in the market. Therefore, no current information can
lead to future predictions of market movement. This view is called as the
efficient market hypothesis.
One of the problems with this view is that many investors and traders
(although still a small percentage of total traders) consistently make money.
Even Warren Buffet, one of the most famous consistent and successful
investors, disagrees with the efficient market hypothesis.
Another group of people claim that the market is perfectly orderly and
predictable. The works of WD Gann who used mathematics and astrology to
predict market movements years into the future are often cited.
My personal opinion is that both theories continue to have followers because
they are both valid, just at different times. Markets tend to cycle between the
times of being orderly (providing high probability trading opportunities) and
chaotic (not providing high probability trading opportunities).
Being aware of this cycle, and being able to identify it is critical to success,
because then you can trade only during orderly cycles and stay out of the
market during chaotic cycles, thereby minimizing the dynamics of making
money on the markets, only to give it all back later. The chart illustrates a
chaotic cycle ending and an orderly cycle beginning (trend).
Interpreting Price Trends
Technical analysts pay close attention to stocks that are rising or falling
rapidly because they think trends like these may continue. Moving averages
are the most commonly used tools to find moving stocks. A moving average
is calculated by adding the daily prices of the stock over a series of days and
dividing by the total number of days.
Moving averages measure the average price of a stock over a specific period
of time. In general, investors pay more attention to the average price of a
stock over one month (30-day moving average), three months (90-day
moving average), or a 200-day moving average.
Technical analysts generally evaluate moving averages in one of two ways:
Stock price is above the moving average: Good, or bullish, news.
Technical analysts think when a stock price is higher than its moving
average, the stock has momentum in its favor.
Share price is below the moving average: bad, or bearish, news. The stock
is starting to break down, and technical analysts would avoid the stock.
If you are looking for short-term trends in a stock, consider using the 30-day
moving average. Longer term traders pay close attention to the 200 day
moving average. Even if you are not a trader, the 200-day moving average is
worth a look because it sometimes explains why a stock might act strangely
at or around a certain price. The 200-day moving average can also be helpful
when looking in the direction of the entire stock market. When stocks rose
above their 200-day moving average in early 2009, it was a sign that the
vicious bear market was over.
Short or Short Selling
If you have reason to believe that a market is going to go down, you can
make money Shorting that market. Short selling (also known as going short
or shorting the market) means that you are selling the market first and then
attempting to buy it later at a lower price. It's exactly the same principle as
buy low, sell high, only in the reverse order, to sell high and then buy low.
You may be wondering how you can sell a stock before buying it. It's actually
not as difficult as it seems. To sell a stock you don't own, for example, you
must first borrow. Your broker makes this process easy and may let you
borrow a stock owned by another trader or less frequently, owned by the
same broker.
When you are ready to exit your final position, cover the position by buying
back the shares you had shorted. In other words, selling before you buy really
means that you are borrowing the stock before you short sell it.
This discussion is intended to be a simple introduction, not an exhaustive
education to fully prepare for shorting the market. Before you short the
market, talk to your broker about the risks and rules of short selling and
educate yourself on all the details. Also note that the rules for shorting stocks
may be different for shorting futures, spot forex, or other markets. Talk to
your agent for more details.
What Makes Short Trading so Exciting
Selling and then buying later (hopefully at a lower price) has several
advantages, including the following: Markets tend to go down faster than
they go up. This is because fear is a stronger emotion than greed. When
people feel scared, they tend to get out of their long positions quickly and
massively. Markets can go into a free fall, and therefore it is usually
possible to make money faster by short selling than by buying, at least for
short periods of time.
By being flexible enough to short, you open up your ability to make
money in various market conditions. When you feel comfortable going
short, you provide yourself with more opportunities to make money.
Shorting options can provide protection against your long positions.
Options are contracts that give the holder the right, but not the obligation,
to buy or sell a stock at a certain price before a certain time. They are
much less expensive than buying the stock itself, and therefore can act as
a type of insurance policy against a stock position.
Taking a short position on a stock with an option would certainly involve
buying a put option. That may seem a bit confusing because you have
short exposure to the stock as the value of the put option increases as the
stock price moves down. The upside is that you pay a small premium,
which can be thought of as a deposit that allows you to sell the stock at a
higher price if the stock moves down.
Coverage is like buying insurance. It is taking a trade that helps offset any
losses that a primary position may take.
The Challenges of a Short in the Market
Like most things on the market, and in life, there are two sides to a coin. If
you decide to incorporate short selling into your personal trading, it's
important to be fully educated on all the implications.
Short selling also has several disadvantages that you should seriously
consider:
It can feel unnatural, and you may struggle to wrap your head around the
concept. It can be psychologically difficult and they feel uncomfortable to
you.
Going short is more expensive than going long. When a stock is shorted,
they borrow the stock and have to pay a fee, albeit a nominal one, to do
so.
In theory, short selling has unlimited risk. If the market goes against you
(going up), there is no limit to how high the price can go.
It can feel unpatriotic to take a stand against a successful company and/or
economy.
Not all actions are available for shorting, and some of those that are
available are not always available. This limits the multiverse of stocks
available for you to trade.
Short selling requires the use of a margin account. It is up to you to
decide if you are comfortable trading with borrowed money.
If you are shorting a stock when it pays dividends, you will owe the
dividend, which will be deducted from your account. Remember, when a
stock is shortened, you do not own it. You are borrowing it from your
broker who still owns it, so you will want the dividend if you are holding
the short position when the company issues dividends.
If a company spins off part of its operations, creating two companies, you
could find yourself shorting both companies. That could be a problem if
you are not bearish on both companies.
Conclusion
Fibonacci levels are a very popular and useful instrument, which works
equally well on both large and small time frames. The Fib lines on the chart
allow the trader to see the reference points for their correction and once
completed, open positions along with the current trade. For greater efficiency,
Fibonacci levels will be supplemented with confirmation signals from
technical analysis tools (strong support/resistance levels, price patterns),
candlestick analysis (candlestick patterns) and other indicators.
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