By Richard Krugel
Introduction to Fibonacci Trading
Leonardo of Pisa, also known as Fibonacci was a famous Italian mathematician during the middle ages and he was the first to write about a special sequence of numbers. When these numbers were added up in a certain way they resulted in a ratio that can be used to describe the special proportions or building blocks that exist within nature.
Today these ratios are known as Fibonacci ratios and the most popular ratio of all is 1.618 or the inverse of that 0.618. Mathematicians and scientists refer to this number as the golden ratio. As in nature, so too does Fibonacci ratios work very well in the world of financial trading when performing technical analysis. They are a very reliable indication of future support and resistance levels that price action almost magically tends to gravitate towards and react from.
There are two main ways of performing technical analysis with Fibonacci ratios: Fibonacci retracements and Fibonacci extensions.
The most commonly used retracement ratios are:
- 0.382 percent.
- 0.5 percent.
- 0.618 percent.
- 0.786 percent.
Let’s use an example of how Fibonacci retracement levels can be used in an upward trending market:
A great way to determine where a pullback or correction that moves opposite from the main trend will end, is to use Fibonacci retracements. Our first chart above is that of Gold and shows most of the upward trend that this commodity experienced in 2016.
To use Fibonacci retracements a trader will connect a low on a chart with a high that materialized after that low (in an uptrend) and by doing this try to determine where that pullback may find support again.
I marked most of the corrections with red arrows, and a closer look shows how well each correction found support and reversed back up again from a Fibonacci retracement ratio. Fibonacci retracement can help traders identify possible breakouts and other indicators of a possible trend reversal.
The most commonly used extension ratios are:
- 100 percent.
- 138.2 percent.
- 161.8 percent.
- 178.6 percent.
- 200 percent.
The following example shows how Fibonacci extension levels can be used, but this time in a downward trending market:
When Gold experienced a downward trending phase that ended around December 2016, Fibonacci extensions could have been used to determine where price may find future support.
Fibonacci extension ratios work well in determining where a trend may find support (in our example). When price does find support either a correction might follow or a trend can come to a complete end.
Analyst or traders that use the Fibonacci extension will connect 3 points on a chart. In our example, a high will be connected with a low and then with a lower high again. The Fibonacci extension drawing tool will then project expanded ratios downwards and these levels will be closely watched for support or change in trend.
I drew two sets of Fibonacci extensions. The first one is indicated by little black arrows and the second set with little red arrows. The green arrows show how well these Fib extension ratios offered support as soon as the price reached them.
Using Fibonacci Levels as Part of a Strategy
Although Fibonacci ratios work well to find levels of support or resistance, I do not use them on their own when making trading decisions. I have found over the years that using a combination of different proven methods work better than relying on one alone.
Instead, I like using a combination of the following:
- Multi timeframe analysis.
- Corrective pattern recognition.
- Market geometry.
- Momentum divergence.
- Reversal candlestick patterns.
My strategy in a nutshell was developed to determine the main trend and then to join that trend at the end of corrections with as little risk as possible.
What follows will be a brief overview of these methods followed by a real example of a recent trade I took when combining all these methods into one.
Multi Time Frame Analysis
When I trade I use 3 charts i.e. a 4-hour, 30-minute, and 5-minute chart. Each time frame serves its own purpose with the 4-hour chart showing me the trend and when a correction is most likely to occur by using my Fib ratios.
My intermediate 30-minute chart is used to look at price action a little closer and to determine which corrective pattern might be developing. I then use various market geometry techniques to pinpoint where that correction is most likely to end. I again use Fib ratios on this chart when needed.
The smallest time frame I use is a 5 minute chart. This is an important chart as I use it as an entry confirmation tool that filters out the bad setups from the good, thereby increasing my probability of success on any particular trade while keeping my risk to a minimum.
Corrective Pattern Recognition
Since my strategy relies on finding the end of corrections, I have made a serious study of what corrective patterns look like and have found ways to exploit the individual characteristics that they tend to repeat over and over again.
Knowing what these characteristics are and using techniques such as market geometry and Fibonacci ratios, in combination with this knowledge, has helped me to pinpoint the end of corrections with a high degree of accuracy.
Market geometry techniques aim to define market structure as all markets display geometric formations that are repetitive in nature. The most common market geometry tools used today are pitchforks and channel lines and they can offer a good indication as to where price might be heading to in the future or find support/resistance. I only use pitchforks as a reliable way of finding the end of corrections.
My strategy relies heavily on pure price action and the only indicator I use is a MACD histogram which is loaded on my 5-minute entry chart. The term momentum divergence simply refers to when the price keeps moving in one direction but the force or momentum of that move has started to decrease. We shall take a closer look at this later.
Reversal Candlestick Patterns
There are hundreds of candlestick patterns that traders can follow to tell them various things. I use a select number of these patterns to confirm the areas I want to trade from, as they tend to pop up when the price is getting ready to reverse. They therefore make a great addition to my overall strategy by telling me it’s time to enter high probability setups with little risk.
Putting It All Together
Now that I have covered all the methods I use in my strategy, I will next show you a real example of a trade on the AUD/USD currency pair that puts all of these methods into action in a systematic fashion.
Step 1: Determine the trend and use Fibonacci extensions on 4-hour chart
Using simple trend lines, I was able to determine that AUD/USD has broken its previous intermediate blue trend line to the upside and its previous market structure (red horizontal line). So the intermediate trend at that time was upwards making me search for long entries.
Using my Fibonacci ratios tool I connected the 3 swings (black arrows) to project my Fib extension ratios upwards, assuming that price will find resistance at one of those levels giving me a corrective pattern.
One can see that price started a corrective pattern when it hit the 1.786% Fib ratio.
Step 2: Identify corrective pattern and where it might end on 30 minute chart
It was not until around the 20th December 2017 that I became confident that AUD/USD was forming one of my favorite corrective patterns i.e. a Symmetrical Triangle correction. When I trade these particular patterns I do not use pitchforks, but I knew that if this was a Symmetrical triangle that I could define it by labeling it as A-B-C-D-E. I know that these patterns always consist of 5 such waves AND that each wave tends to end at Fibonacci retracement levels.
These are the characteristics of corrective patterns I was talking about earlier and knowing these sorts of things provides me with the confidence to trade setups with a high degree of probability and confidence. Just look at which Fib ratio levels each wave reversed from!
I knew that wave E would terminate at one of my Fibonacci retracement ratios giving me enough time, in advance to prepare myself for an entry.
Step 3: Look for momentum divergence and reversal candlestick patterns at area of entry.
The last step in the process was to first spot momentum divergence (at the area I identified before) and then secondly look for a reversal candlestick formation to confirm an entry.
The MACD histogram is loaded on the bottom panel of my 5-minute chart and it showed that although the price was moving downwards into my entry zone that momentum was drying up or diverting from what price was doing. This is called momentum divergence and most reversals at the end of corrections will display this phenomenon.
All that I had to do next was to wait for one of the reversal candlesticks I track and I got that confirmation when the green reversal candle appeared right at my area of entry. This meant that I could now proceed to place a buy order slightly above that candle with a stop loss just below it.
Following the above-mentioned process enabled me to enter a trade with very little risk, right at the end of the correction, before price resumed the intermediate trend that I identified on my 4-hour chart.
My target was set at the start of the correction that I identified and price reached my target in quick succession resulting in a profit that well exceeded the risk I took on.
Using Fibonacci ratios to find areas of support or resistance can provide us with many tradable opportunities especially when used in combination with additional methods that follow a systematic approach.
If you’re interested in taking your trading to the next level, and you’re serious about treating trading like a business, be sure to check out my video training below.
Until next time, happy and profitable trading.
We’ve only scratched the surface of understanding market structure and how to trade within it.
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