An Objective Leading Indicator Fibonacci Retracements

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1 An Objective Leading Indicator Fibonacci Retracements This article explains how to use Fibonacci as a leading indicator, combining it with other technical analysis tools to provide precise, objective entry points for a trading strategy. A leading indicator means that you can decide on likely direction ahead of it happening as compared to a lagging indicator which only predicts movements after it has already started to occur. As Fibonacci is a leading indicator you will see the entry point and place an order in advance of the market reaching your desired level. F1) Fibonacci Retracement Ratios o This strategy can be applied to all liquid, technical markets and can be applied across time frames from one minute up to one month. Fibonacci Leading Not Lagging Some may argue that Fibonacci is a subjective indicator or one that only works in hindsight but then again smart people the world over always have and always will continue to hold contrary views. The important thing in trading is that you find what works for you and stick to it. Fibonacci is a great leading indicator once you know how to use it correctly. Retracement levels used by Precision Traders are 38.2%, 50%, 61.8% and 78.6% only. The article will explain: Fibonacci as a part of your current trading strategy or any strategy involving pullbacks/retracements. A precise trade entry point where Fibonacci levels cluster. Correct stop-loss levels. 48 February

2 Fibonacci extensions for target setting. Other technical indicators to use in conjunction with Fibonacci. F2) Price Action Uptrend Is Fibonacci Scientific? Fibonacci has some scientific foundations and its study is used across far more subjects than financial markets. Fibonacci has links in the human body, animals, breeding patterns, nature and religion. If you want a history lesson on Fibonacci, all it takes is a quick Google or Amazon search and you will be spoilt for choice. While it may be interesting, history lessons rarely help you make money. This article focuses on using Fib as part of a technical trading strategy, in fact, any technical trading strategy that involves trading pullbacks of a trending market. The goal, as with any good strategy, is to give you extra edge in the markets and ultimately make you a more profitable and consistent trader. Is Fibonacci Self-Fulfilling? In short, no. For a technical indicator to become self-fulfilling it implies that not only are many traders using it, but that they are all using it the same way and actually applying the analysis correctly. Fibonacci is based on a combination of trends, mathematics, trading skill, experience, intuition and lots and lots of practice. Because someone draws a Fibonacci line on a chart does not mean they have any of these required ingredients. Having a strategy is just one thing, applying it correctly and consistently means you own it rather than simply understand it. This can only come through years of practice, highs and lows. What Is a Fibonacci Retracement? After a move up or down in the market, at some point the market will start to pull back or retrace this has to happen. No market can go in one direction for ever. As the market starts to retrace, a good trader will draw a Higher highs (HH) and higher lows (HL); understanding when a market is trending and the precise moment that the trend reverses is the most important thing a trader can ever do. It s also very simple, most new traders just don t put enough emphasis on it. Fibonacci line from the start to the end of the move to see the probable points of retracement. This results in multiple lines drawn horizontally across the chart that the price may be supported or resisted at if price reaches them (see Figure 1). Common retracement levels are 23.6, 38.2, 50, 61.8, 78.6 and 100 percent. This means that after a move in either direction (which equals 100 percent), the retracements could be 38.2 or 50 percent or so on, back in the opposite direction of the 100 percent move. If the full move reversed, then this is considered a 100 percent retracement. The problem is that as the price retraces, there are many retracement levels to choose from. Which level is the market most likely to turn at? More importantly, where is a good place for you to enter a trade? At this stage we don t have enough information to answer that question; there is no high probability trade with just this amount of analysis. This has February

3 F3) Price Action Downtrend Fibonacci) is what will make them more money and open up the secrets to wealth and success through trading. This is not true, not even close to it! Without a grasp of basic technicals, the advanced stuff never quite makes sense. Correct trend analysis is the most important thing that a trader can ever understand. It is also essential for drawing Fib lines correctly there is no retracement without first having a trend. Lower lows (LL) and lower highs (LH); same as Figure 2. An uptrend is: A series of higher highs (HH) and higher lows (HL) (Figure 2). An uptrend is over when this trend reverses, i.e. the price makes either a: Lower high (Figure 2 point A) and/or, Lower low (Figure 2 point B). A downtrend is: A series of lower lows (LL) and lower highs (LH). See Figure 3. A downtrend is over when this trend reverses, i.e. the price makes either a: Higher high (Figure 3 point A) and/or, Higher low (Figure 3 point B). F4) Correct Drawing of Fib Lines Correct drawing of Fib lines within a downtrend, starting from the most recent high and drawing to the most recent low. led some people to say that Fib is subjective. Well, the truth is, it is subjective but only for those people who don t have a precise strategy for how to use it. If you cannot pinpoint a trade with precision, i.e. the exact retracement level that you would like to buy or sell at, then you do not have a trading strategy. All you have is a very subjective and borderline useless trading tool. So, let s cover how you can pinpoint the precise Fib retracement level that has the highest probability of the market turning. To understand the full trading strategy you must first understand trends at the basic level. Trends A Series of Highs and Lows Trend analysis is the most straightforward, most important and yet most overlooked technical tool at our disposal. Many traders skip over it because they think higher highs and higher lows is too simple. They think the advanced stuff (such as Fibonacci Is for Trending Markets Only Important rule only draw Fib retracements when there is a prevailing trend. All trends have to retrace in order for the above definit ions to be true, i.e. in an uptrend price has to pull back from an HH to make an HL. Trading with the trend is also the highest probability trading looking for a retracement of the current trend ensures you have momentum behind the move. If there is no clear trend then by using Fib retracements you are swimming upstream before you even begin. Fib does not work in ranging markets! The nature of a ranging market is that it will range between two levels, hence pulling back approximately 100 percent of each prior move retracements in this situation are useless. Now that you are trading with the trend, you can draw your Fib line in the direction of that trend. A start point for this line should be an HL within an uptrend or an LH within a downtrend. Refer back to Figure 2. Each HL was a possible start point for your Fib line. You should draw it upwards in the direction of the trend. Equally, in Figure 3, each LH was a place to start a line from and draw downwards in the direction of the trend. The most important place to start from is: The most recent low within an uptrend. The most recent high within a downtrend. Remember the above points as they are the most crucial steps in applying Fib correctly. This will ensure that you are only looking for retracements of the current trend in the time frame you are trading. Caution do not look for retracements of a trend that has just reversed. For example, look at Figure 3. We have now reversed the downtrend and are uptrending (made an HH & HL) so there is no point drawing a Fib line downwards any longer. In fact, if you were to draw a line on this chart right now, the only place to do it would be with the uptrend from the last LL up to point A. Completing the Fib Line 50 February

4 There are highs and lows all over the chart, so which one do you use? The answer is very simple: The line should always end at the extreme, i.e.: The most recent HH within an uptrend or, The most recent LL within a downtrend. F5) Fibonacci Cluster within an Uptrend We clarified earlier that in the absence of a trend, there is no Fib retracement to be drawn. Also, once a new high or low has been made (a new extreme), new Fib lines need to be redrawn, your old ones are now invalidated as you would no longer be looking at a retracement of the current trend. Look at Figure 4 for an example. You MUST draw your Fib line as shown from point D (the most recent high) down to point E (the most recent low or the extreme). There is no point drawing a line from C down to X2 any longer. X2 was a valid low when it was the extreme, however now a new low has been made at E and this is the ONLY point where Fib lines should end. To Confirm: Short-term move Within an UP trend, you MUST always draw your Fib line starting from the most recent low and finishing at the most recent high. Within a DOWN trend, you MUST always draw your Fib line starting from the most recent high and finishing at the most recent low. Both of the above are considered the Short-term Move. Long-Term Move All Fib lines must end at the same point, you can, however, start from different points, drawing to the same end point. We refer to this as the long-term move. This is how you can locate clusters and is also how we start to build a high probability entry point. Locating Clusters of Support and Resistance Again looking at Figure 4, we know that the line has to be drawn from D down to E as this makes sure we are only trading a pullback of the current trend. This, however, leaves us with four potential retracement levels. To define a potential entry point, we look to see if any Fib retracements cluster at the same level. To do this, you must use a different start point for your Fib line and finish at the same end point. See Figure 5 which shows the same chart as Figure 4, however this time we are drawing a second Fib line from a different start point, C, and finishing at the same end point, E. Note that the 38.2 percent for the long-term move down (C to E) overlaps with the 50 percent of the short-term move (D to E). This is what is referred to as a Fib cluster and becomes a much higher probability turning point if the price reaches there. The same is very true in an uptrend. Refer to Figure 6 which shows a cluster of the short- term 50 percent and longer-term 38.2 percent. See Figure 7 to see what happened when this level was tested. Correct Usage of Each Fib Retracement Level While there are many more Fib retracement levels, Precision traders only use certain levels and for various uses as follows: 38.2 percent: By nature of the fact that we are looking for The figure shows a cluster of the short-term 50 percent and longer-term 38.2 percent. clusters for an entry point, the 38.2 percent will only be used for the long-term move, e.g. a 38.2 percent move for the longer term may cluster with the shorter-term 50 percent or 61.8 percent level. 50 percent: Buy zone look for 50 percent pullbacks of the short-term move when there is a cluster of support/ resistance at the same level percent: The buy zone as with the 50 percent level, you should look to buy 61.8 percent pullbacks of the short-term move but only when this level clusters with other support/ resistance at the same point percent is known as The Golden Ratio and is perhaps the most powerful of all Fib retracement levels percent: This level should not be used for entry and F6) Correct Using of Locating Fib Clusters Following on from figure 4, this figure shows the correct usage of locating Fib clusters, starting from the previous high and drawing to the same low. Note the point of cluster. February

5 F7) Market Bounces than this. Your target is the old high/low or the 0 percent level, i.e. you expect the price to retest the extreme high or low A further profit target for those who prefer to scale out of trades is to use Fibonacci extension levels. The 127 percent extension is a sensible next target. Pullback Strategy Improvements Other technical factors can and should always be considered and this stands for any trading strategy that you employ. Have as many reasons for entering a trade as possible! Some areas to consider: Market bounces of the cluster illustrated in Figure 6. is for stop losses only your stop should be placed behind the short-term 78.6 percent retracement level. The reason for this is that the further the price pulls back, the higher the probability that it is actually a reversal as compared to just a retracement. Once the price pulls back over 78.6 percent, there is a far higher probability that it will actually retrace the full 100 percent. Hence, a stop behind 78.6 percent protects your losses by having a slightly tighter stop than using the 100 percent level. This equally results in a more favourable reward-to-risk ratio. 100 percent: This means that the full move has reversed. Use this for stops only in a situation where you would like a slightly wider stop than the 78.6 or where the 100 percent adds significantly to the probability of your trade, e.g. it is a major support level. Note that we do not use the 23.6 percent pullback, this is simply too small a pullback for a high probability entry point. Fibonacci Retracement Trading Strategy This analysis can be applied across any market and in any time frame although it will work best on highly liquid markets where there are many technical traders. Two markets that match these criteria well are the large index futures markets such as the mini S&P (ES) and mini Dow (YM) and spot currencies. Enter at the precise point of the cluster, i.e. as the price touches it. Not before and definitely not after. Only trade with the direction of the overall trend. Your confirmation is the fact that you have a strong cluster within a strong trend. Do not wait for the price to turn around at this level, by then it is too late. If you wait for the price to do what you thought it would, then you have missed the trade. We are using leading indicators here to predict the move in advance. Your stop loss should be placed behind the 78.6 percent retracement level. More conservative traders could place their stop just behind the 100 percent level but do not have a stop any wider Trend Look for convergence and divergence between price action and indicators to assess trend strength. Use trend following indicators such as the ADX or DMI. Assess trends in multiple time frames. Look for moving average buy & sell zones in addition to Fib buy/sell zones. Clusters of Support and Resistance Look for proven price action support and resistance at the same levels, i.e. price has tested and failed at that level before, adding further strength from non Fib users. Pivot points - the most powerful, individual technical tool at a trader s disposal. Find a pivot (or a cluster of pivots) at the same point as your Fib cluster and you have a VERY high probability trade. This forms the basis of the Precision Trading Strategy. It also happens far more often than you may think. There are numerous ways to improve upon the success of this strategy. There are many technical tools and strategies out there and you can t use them all but if you have something that is working for you, keep on using it and use it to add value to all trading decisions that you make. The philosophy is quite simple Have as many reasons as you possibly can for every single trade that you place. The more reasons you have occurring all at the same time, the higher the probability of the trade being a success. To succeed as a trader, that is exactly what you need the confidence in your strategy that you have more chance of winning than losing. And of course the ability to execute precisely according to your rules. Execute well! Nick McDonald Nick McDonald is a full-time trader in addition to acting as a mentor for aspiring traders. Nick founded Trade with Precision to filter out unnecessary information from trader training and instead focus on teaching people real trading strategies that he himself uses to trade the markets daily. You can find out more about upcoming workshops at 52 February