Fibonacci Retracement and Extensions
As I can't find a suitable set-up today, I've decided to talk about how to use one of the tools that I have been using frequently. The Fibs and the golden ratio.
The fib tool is probably one of the most talked about tools in trading. Its scary how accurately prices bounces off these levels of fibs like voodoo magic sometimes. Some people say its nature's order while some attribute it to the self-fulfilling prophesy aspect to it as so many traders eye the same level of prices it highlight.
First and foremost, if you are planning to use fibs for short period charts, I would suggest you to drop the idea. The risk and reward ratio and the commission you pay for each position would swallow you up before you even know it.
I use fibs to determine support and resistance levels of a trend. Below is a chart of USD/JPY last week.
Finding Entry Points
To draw a fib retracement, choose the trend high to the trend low as your points.
As we can see, a simple upward trend was forming from 27th Sep - 30th Sep. If you studied elliot wave, you would have identified that to be a beautifully formed wave. I'll explain that next time.
It was deemed for a corrective wave when price peaked on the 30th Sep. We never know when it'll peak so there's no point trying to short it down to catch the corrective wave. But when prices went below the previous low, we knew that either a reversal or retracement is happening.
Fibs are made up of ratios which we will not go into detail on how it is calculated. One thing I've learnt for sure is to be wary of the levels 0.382, 0.5 and 0.618. 80% of the time, prices would react to these levels and bounce off these levels. A cut below 0.618 usually signifies a reversal while a bounce could represent hesitation or an extension is forming.
For me personally, I have placed a long order at the 0.5 level which I'm comfortable with and a stop loss below 0.618 level. The gap you want to place below the 0.618 depends on the risk you are willing to take. My advice is to place a larger gap as prices often spikes below 0.618 levels and immediately buys back. If it dips way way below 0.618, it could represent that a reversal is happening.
Exit Points
To find exit points, we draw fib extension similarly by selecting the bottom of the trend low to the trend high.
Somehow the trading platform I use does not have the 0.8 fib level and 1.28 level. Ideally, if prices is indeed a strong retracement, prices would balloon up to 1.28 levels. In a weaker trend such as the above, we could see prices being caught in a range.
How I would set my exits would be to set half my position to close out at 0.8 fib level, the yellow line I drawn manually and another half at 1.28 level.
Why? the 0.8 fib level is a strong level most traders fail to recognize. Naturally, prices will usually retrace to that level before deciding whether to go higher or lower. My current strategy is to lock in half my profit at this level while hoping that prices go up to 1.28. I would also have bring up my stop loss to 0.618 levels to lock in profits if price were to reverse. I agree that it is a little tight for prices to move to set such tight losses but what I want to catch is not ranges like the above but real reversals that would balloon to the 1.28 levels. Such ranges above are prone to reversals and hence locking in profits and having stop losses to lock in profits are advisable.
That's all for fibs tool which I'll be using almost in every trade I make following on. Stay tune for more. One thing I've learnt in trading is that you will never always be correct. What we want is to have a higher proportion of being correct say 60% of the time and to let profits run while cutting losses fast.
