Part 1- Introduction
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 exists 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 which price action almost magically tend to gravitate towards and react from.
There are two main ways of performing technical analysis with Fibonacci ratios namely Fibonacci Retracements and Fibonacci Extensions.
Fibonacci Ratios and Retracements
The most commonly used retracement ratios are:
- 0.382 %
- 0.5 %
- 0.618 %
- 0.786 %
Let’s use an example of how Fibonacci Ratios and Retracement levels can be used in an upward trending market:
The chart above shows the GBP/USD on a 4 hour chart. The green arrow on the left shows that price was advancing upwards into an area (marked by the red down arrow) after which price declined temporarily into an area (marked by the green up arrow) before resuming the previous upward trend. If we were of the opinion that the market would continue its upward trend, then the most likely area where a correction might end is at a Fibonacci retracement ratio.
To use a Fibonacci retracement tool, one would need to connect two prior swings with each other. In our example the trend was up, so we would need to connect the previous swing low (marked as A) with the most recent high before the decline started (marked as B).
That would give us our Fibonacci retracement levels where price is most likely to stop before advancing again. In the example above price touched the 0.618% fib level before resuming the main trend again. A closer look at our chart will also reveal that price struggled to close below the 0.5% fib level. These were all signs that support was coming into the market and that price was very likely to resume upwards again.
Here is another example of how well Fibonacci retracements contain price in a downward trending market:
From the left side of the chart we can see how price has been moving downward into an area. If we were to assume that price will continue downward then we would have used our fib retracement tool and connected the recent high at A with the low at B to find possible resistance as price made a correction upward.
After point B the GBP/USD in this example entered a consolidation phase but it is clear to see how price reacted from the 0.5 %, 0.618% and 0.786% fib retracement levels indicated by the red arrows.
The Fibonacci retracement ratios have done a great job at providing resistance in our example and price never went higher than the 78.6% fib ratio before heading downwards again and continuing the initial trend direction.
My Favorite Fibonacci Ratios and Retracements
Whenever I trade using Fibonacci retracement ratios, I prefer to only use 3 levels and I color code them as follows:
- 0.5 % in black
- 0.618 % in gold
- 0.786 % in dark orange
All that Fibonacci retracements are really doing (using our example) is dividing the distance in height measured from A to B using Fibonacci ratios i.e. 0.5% is exactly half of the height between A and B.
When using Fibonacci retracements we are trying to find levels of support or resistance when dealing with counter trend corrective phases.
The most commonly used extension ratios are:
- 100 %
- 138.2 %
- 161.8 %
- 178.6 %
- 200 %
The following example shows how Fibonacci Extension levels can be used in a downward trending market:
Staying with GBP/USD on a 4 hour chart one can clearly see that there was a down trend from the high of A all the way down to the last red arrow at the bottom. If we were to open our chart around the time that price stopped at B and we had any sort of correction upward (in this case C) that reversed downward again breaking the low of B, then that would have been an opportune time to use our Fibonacci extension tool.
To use a Fibonacci extension tool, we would need to connect 3 swings this time around and as per our example we would start at A, connect it to B and then lastly C. What the fib extension tool will do is extend ratios forward in time which would provide us with possible future levels of support.
I marked all the areas with little red arrows that clearly shows how price reacted against our fib extension ratios when they were eventually reached.
Below we have an example of an upward trend in GBP/USD:
The GBP/USD has been moving upward from point A before reaching a level at point B that caused a minor retracement downward into point C before moving upward again breaking the high of point B.
When that happened we could have immediately used our Fibonacci extension ratios to determine future areas of resistance and possible clues where price might be heading to in the future.
Using our fib extension tool we would have connected point A to point B and lastly with point C and we can clearly see from the fibonacci chart that price gravitated towards our fib extension ratios which also provided areas of resistance that price reacted to.
My Favorite Fibonacci Ratios Extensions
Whenever I trade using Fibonacci extension ratios, I prefer to only use 4 levels and I color code them as follows:
- 100 % in green
- 138.6 % in aqua
- 161.8 % in gold
- 200 % light green
Fibonacci price extension levels therefore use 3 points of a previous swing and project ratios forward in time and into the same direction that we assume price would be moving towards and in our example that was downward.
Fibonacci extensions ratios are great to use when judging where price is likely to be heading to and can also indicate when a trend might be nearing its end.
Part 2 – Additional Confirmation Methods
So how can we actually use these fibonacci ratios to find precision entries?
The short answer is to trade from Fibonacci levels with the direction of a trend but to do so effectively we would need 3 additional confirmation methods to stack the probabilities in our favor.
- Multi Time Frame Analysis
- Momentum Divergence and
- Reversal Candlesticks
Confirmation Method 1: Multi Time Frame Analysis
When hunting for precision entries we are basically trying to find the sweet spot where a trade has the highest probability of succeeding with the least amount of risk. One way to do exactly that is to open two charts of the same market.
In all the examples that follow later on, we will be using a 4 hour chart as our higher time frame chart and a second chart (set to 5 minutes) as our lower time frame chart.
Since we will be looking at the same market, all that the higher time frame will do is to provide us with a “bigger picture” view of price action. The smaller time frame on the other hand will be used to give us a “zoomed” in view of price action from where we will find our precision entries.
Let’s explain this with two chart examples:
Chart 1: 4 hour
Above we have a 4 hour chart of GBP/USD again that provides us with a bigger picture view of price action. We can also see how price touched the 0.618% fib retracement level before resuming the initial trend upwards (blue box).
Every price candle took 4 hours to complete and a lot of price action can take place in 4 hours. If we were to wait for confirmation from the 4 hour chart before taking a trade then price could have moved so far away from the fib retracement level that our associated risk with the trade would have been too high.
It is always advisable to wait for confirmation signals when taking a trade and there will be more methods to follow later on that illustrates how we can enter trades with better precision.
Let’s say we waited for confirmation and entered just above the second green bullish candle in the blue box, then we would have to place a stop loss order to limit our risk. A good place to place a stop loss order would have been just below the 0.618% fib retracement level.
Using a chart ruler in our example and we can see that the stop loss order would have been roughly 52 ticks away from our entry order.
Maybe we could have entered with lower risk and an increase in profit potential?
Chart 2: 5 minute
Our second chart displays the exact same area with the blue box shown on our 4 hour chart previously. The 5 minute chart gives us a zoomed in look at price action at the same area and if we have placed an entry order just above the candlestick that reacted from our fib retracement level then our stop loss order would have been just below the fib level.
Have we used a 5 minute chart to enter then our risk in this case would have been only 8 – 9 ticks instead of 52 ticks! This entry method would have reduced our risk considerably while at the same time increased our profit potential.
When entering trades I like to therefore use my 4 hour chart to draw my fibonacci levels from and only once these levels are reached will I switch over to my 5 minute chart to “fine tune” my entries. This reduces my risk and increases my potential profit.
Confirmation Method 2: Fibonacci Ratios Momentum Divergence
As price move around on a chart it does so with a certain amount of momentum. Sometimes very fast and sometimes very slow. Price momentum can be explained as the rate or speed at which price accelerates. Price acceleration is typically strongest at the beginning of a new directional move and when price acceleration slows down then that move can end up in a correction or a change in trend.
What we would use later on is a condition called momentum divergence and all that refers to is when price keeps making a directional move but momentum in return starts slowing down. So when momentum is doing the opposite of what price movement is doing it is called momentum divergence.
We will be using a MACD indicator to show us momentum divergence and it will be applied to our 5 minute chart only. Below is an example of momentum divergence.
From the chart example above we can see how price moved downward, but notice how the MACD indicator on the lower panel (set to only display the histogram) moved in the opposite direction upwards indicating a decrease in momentum, which ultimately caused price to reverse. This is called momentum divergence and it will be a useful tool later on to help us confirm precision entries.
Confirmation Method 3: Fibonacci Ratios and Reversal Candlesticks
Certain candlestick patterns, at precise areas we are interested in trading, can provide additional clues that a reversal can take place at any moment. We will be relying on them to provide additional entry confirmation when trading. Below are the candlesticks I like to see when considering an entry:
One type of reversal candlestick pattern we would like to see are called Engulfing Candles. The oval circle in red on the left shows a bullish engulfing candlestick and the oval circle on the right shows a bearish engulfing candlestick. They are called engulfing candlesticks because they are much larger than the prior candlesticks, their bodies therefore “engulf” the previous candlestick and typically starts a new direction in trend.
Another type of reversal candlestick pattern is called the Hammer Candlestick. The red oval on the left is called a bullish hammer and the red oval on the right is called an inverted hammer (or bearish hammer). They typically have no, or very small wicks when they open, after which price will move up or down but close near their openings again leaving very large wicks. These wicks are typically larger in size than the body of the candle after the candle has closed. They are good indications that buying or selling pressure has dried up and that a reversal might follow. Take note that our example on the left actually had two bullish hammers forming in succession and when we use them for confirmation their bodies can be either red or green, we are only concerned with their shapes.
The second to last type of candlestick patterns I like to see are very similar to the Hammer candlestick pattern with the only difference being they do not have flat tops or bottoms. I simply call them Reversal Candles. What they have in common with hammer candlesticks are their long wicks but they always close higher or lower than their opening price in the opposite direction.
The red oval on the left is a bullish reversal candle. When that candle opened it made a new low but it closed high off that low leaving a tall wick in the direction of the reversal.
The red oval on the right is a bearish reversal candle whose wick made the last high before moving strongly lower and closing lower than its opening price, again indicating a reversal.
Part 3 – Formulating Fibonacci Ratios Plan
We have covered what Fibonacci Ratios are, we also know that we can look for potential trades around these ratios and we discussed methods that can provide us with additional confirmation that increases the probability of a trade being successful.
To take full advantage of what we know we would need to formulate a plan to take advantage of this knowledge. What follows is a step by step process that would help you to only take the trades with the highest probability of success and the least amount of risk.
Are you at a Fibonacci level on your 4 hour chart that you would like to trade from? – If YES, proceed to step 2
Do you have momentum divergence on your 5 minute chart at that fib level? – If YES, proceed to step 3
Do you have some sort of reversal candlestick pattern present at the fib level? – If YES, proceed to step 4
If you were to enter a trade would your risk be within your acceptable risk tolerance? – If YES, take the trade!
The 4 steps above are all that is needed to formulate an actionable trading plan using Fibonacci ratios. In Part 4 we will use these exact steps with chart examples to show you how to exactly trade your plan.
Part 4 – Fibonacci Ratios Precision Trade Execution
During part 1 we had a look at a 4 hour chart of GBP/USD when we discussed Fibonacci retracements. Using that same example, let’s proceed by following the steps of our trading plan to see if there was indeed a tradeable setup.
Q: Are you at a Fibonacci level on your 4 hour chart that you would like to trade from?
A: Yes, price retraced to the 0.618% Fibonacci level on the 4 hour chart.
Proceed to step 2…
Q: Do you have momentum divergence on your 5 minute chart at that fib level?
A: Yes, the MACD indicator has been moving in the opposite direction than price action, creating momentum divergence (indicated by green arrow in lower panel).
Proceed to step 3…
Q: Do you have some sort of reversal candlestick pattern present at the fib level?
A: Yes, in fact we had two reversal type candlesticks, the first was a bullish inverted hammer (red ellipse on the left) and the second was a bullish flanked doji (red ellipse on the right).
Proceed to step 4…
Q: If you were to enter a trade would your risk be within your acceptable risk tolerance?
Before we proceed to Step 4’s answer, please note that I would have personally taken this trade because of my own risk tolerance. I will also be using the second flanked doji reversal pattern as an example. We will discuss the importance of risk management later on in Part 5.
A: Yes, If we placed a buy order two ticks above the bullish flanked doji pattern then our stop loss would need to be two ticks below the reversal pattern. The distance of my stop loss order from my entry order would have been well within my acceptable risk tolerance and in this case only 16 ticks.
The 4 steps above would have helped us to take a trade following a systematic process. If any answer to the questions were NO, then a trade entry should not have been considered.
Entries, Stop Losses and Targets
During step 4, I mentioned that an entry order would have been taken 2 ticks above our reversal candlestick pattern. This will be the same for any entry order, both long or short as our entry will always be two ticks above or below a reversal candlestick pattern after all of our steps have been adhered to.
We should always protect ourselves against potential losses in our account. It is therefore critical that a stop loss order be placed immediately after your entry order has been filled. Stop loss orders should be placed two ticks above/below the reversal candlestick formation that got you into the trade. The size of your stop loss should also be taken into consideration. If the stop loss was too far away for your risk tolerance, then you would have to miss the trade.
Our examples above would have gotten us into a trade with a protective stop of only 16 ticks but what about a target order? After all we are here to make money, so where would the best place have been to book our profits?
We should always aim for a target that is at least 2-3 times larger than the risk we are taking on. I like to aim for previous swing highs or lows that occurred prior to the retracement. Above we have our 4 hour chart again and if we were to aim for the prior swing high before the retracement occurred then we would have had a target of 172 ticks which was 10.75 times higher than the risk we were taking on. I like those sort of odds!
Another important note to make here is that the entry order would have been very near to the lowest point made on the 4 hour chart, that’s why we used a 5 minute chart to “zoom” into price action for a precision entry.
Part 5 – Risk Tolerance
Every trader will have a different tolerance to risk. When we trade it is always a good idea to only risk 1 – 2 % of our account equity on any one trade. This way we can afford to be wrong a few times without blowing up our accounts. As long as we follow a strategy that has a high probability of success, with a higher reward versus risk ratio then we stack the odds of being successful in our favor.
You only need one or two trades, as per the examples I showed you to gain huge rewards of 10:1 and upwards to really boost your account.
If any trade requires you to risk more than 1 -2 % then it would be wise to skip the trade and look for another opportunity. There will always be more opportunities and taking only the trades that satisfy our trading plan will ensure that we are around long enough to make trading a profitable endeavour.
Using Fibonacci ratios to find areas of support or resistance can provide us with many tradeable opportunities especially when we use additional confirmation methods and follow a plan. Judging by the examples you have seen it is even possible to bank much larger profits than the risk you are taking on in any given trade. Sometimes even 10 times more!
The intention of this article was to provide you with an actionable plan to trade Fibonacci retracements but for those of you who want to expand their knowledge to include even more wonderful concepts, then be sure to check out our advanced course (link here).
Our advanced course will teach you powerful concepts in how to combine Fibonacci ratios with market structure and geometry to find many more low risk trade setups that will greatly benefit any trader that is ready to take their trading to the next level.
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Until next time, good bye and happy trading