The Fibonacci retracement tool is one of the tools used in technical analysis and is based on the Fibonacci numbers.
Markets tend to move in a trend, but this movement is not in a straight line. Rather, the market trend flows and ebbs like the tide of a river, experiencing periods of surge in movement and pullbacks. In other words, markets experience dips and rallies in the context of uptrend and down-trending movements respectively. These dips and rallies are caused by profit taking from traders who had earlier taken positions at the start of a trend. Dips within an uptrend, or rallies within a downtrend are known as retracements. Dips and rallies therefore present a second chance for those who missed the initial trend movement to get in on the trend once again. The major challenge for traders who want to re-enter the trend is: how are these entries made? It is for these traders that the Fibonacci retracement tool was created.
The Fibonacci Retracement Tool
Retracements are a constant occurrence in the financial markets. Therefore, when you pull any charts on your forex platform within the context of a trend, you will notice that there are periods of retracements within the trend.
You will also notice that the trend continues once the retracement has ended. This is because when prices have fallen to an extent where they are deemed more attractive to traders, they will start to get in on the trend once more. In addition, those who have been taking profit may decide to get in on the action once more.
The Fibonacci retracement tool paints 5 or 6 levels (depending on settings) on the chart. These correspond to Fibonacci numbers that display possible areas to which the price action will retrace to before the trend resumes. These Fibonacci retracement levels are:
Most of the retracements occur to the 38.2%, 50% and 61.8% retracements. But there is no point in guessing because markets are unpredictable. So while these Fibonacci retracement levels are possible areas of entry, the trader must know the specific retracement level where an entry can be made. To do this, some other tools can be used to effect the entry. One of these tools is a marker of overbought and oversold conditions, and this is the Stochastics Oscillator. So how can the Fibonacci retracement be used in raking in profits from re-entries in forex trading?
The strategy has three components:
a) The setup
b) The trade entry
c) The trade exit.
The setup is performed on long term charts such as the 4-hour chart and the daily chart. These charts are used because they are the reflection of a true trend. Using lower time frame charts will lead to errors, as what may look like a trend on a one hour chart may be a retracement move on the daily chart. The Fibonacci retracement tool is attached to the chart by tracing:
a) from the highest candle point on the chart to the lowest candle point on the chart in a downtrend.
b) from the lowest point of price on the chart to the highest candle point on the chart in an uptrend.
Select the Fibonacci tool (Insert -> Fibonacci -> retracement) and click on the corresponding points. This plots the Fibonacci retracement areas on the charts. Also, select the Stochastics oscillator (Insert -> Indicators -> Oscillators -> Stochastics) and adjust the settings to 10,3,3. This completes the chart setup.
The trade entries are made using the following rules:
a) Long Trade
This is done in an uptrend. Look for where the price action retraces to a Fibonacci retracement level at the same time that the Stochastics oscillator is at a level considered to be oversold (i.e. 25 or less). Enter the long trade at the open of the new candle.
Long Trade setup
The trade entry here is straightforward. There is an uptrend and the price is traced from the swing low to the swing high, which on the 12th of July was at the area where the Fibonacci trace ended. Every other price action after then is futuristic but we have used the chart to show how the trade would have played out from 13th of July up until the 21st of July. The price retraced from the high on July 12th on the chart, to the 50% retracement level which was where the lines of the Stochastics oscillator crossed at the oversold level of 25. The next candle opened and went bullish immediately. The open price of this candle is where the long trade should be initiated.
b) Short Trade
Price stops retracement at a Fibo retracement level where the Stochastics oscillator is at a level considered to be overbought (75 or higher). Go short at the open of the new candle.
Short Trade setup
Here, the trace is performed from the swing high of May 13th 2015 to the swing low of June 1st, 2015. The price retraced to the 61.8% line when the Stochastics was overbought on June 19th, 2015. The short trade is entered on the open of the next daily candle.
The trade exit is defined by the settings for the Stop Loss and Take Profit. In setting the profit target, we use the Fibonacci expansion tool. To use tool, the trace is started by taking the trace from the retracement tool and extending it to the exact retracement point. This tool should be applied to the chart only after the trade entry. This is because you need the retracement level at which the trade entry was made to trace the expansion tool accurately.
Profit Taking with the Fibonacci Extension
The stop loss is set below the Fibonacci level immediately below the one used for trade entry for the long trade, and also set above the Fibo retracement level located immediately above the one used for short trade entry.
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