Fibonacci Trading Strategies – An Introduction
INTRODUCTION
Fibonacci trading refers to a set of strategies driven by a popular method of market analysis. It’s popular not only in the Forex (currency trading) markets but also among professional traders of stocks, futures, and other markets around the world.
There are countless ways to use Fibonacci levels and these seemingly magical ratios can be used to predict price action — that is, “to predict with better than 50/50 coin flip” odds, which is all a trader really needs. They don’t tell the future or guarantee 100% winning trades, but they show you where price is likely to continue (rather than stop-and-reverse; more on this later.)
Fibonacci was named after Leonardo Fibonacci, a mathematician who discovered a number pattern that explains many of nature’s patterns, from spirals to the birth patterns of various species. None of that is really important to a Forex trader… except for the fact that the ratio between Fibonacci’s numbers is one of the most popular methods of projecting market corrections.
Does it really have anything to do with the patterns that naturally occur? Honestly, it doesn’t matter.
Whether you believe these patterns always occur because of some major formation of crowd psychology (some people actually believe that they occur in the markets just like they occur in nature) — or even if you believe that they’re nothing more than a self-fulfilling prophecy caused by the “market movers” — all that matters is that it works… more often than it doesn’t.
That’s right, I said it just works “more often than it doesn’t.” That’s really all I have to say about one of the methods that helps keep food on the table here.
That line may not sound as exciting as some of the Forex product ads you’ve seen before — because, well, the reality isn’t that overblown and exciting — sometimes, it can even be boring. But would you rather be making money, or getting an adrenaline rush? (Seriously, ask yourself this now before you waste thousands of dollars on an adrenaline rush.)
I’m not going to fill your head with dreams about a holy grail trading method because everyone who’s been around in this business for longer than a year already knows you can only find those in colorful Forex scam products (or so they claim anyway.)
The truth is: professionals just need tools that allow a trader to be right more often than wrong, in one way or another. In fact, many of us barely even need that to make money… as long as the method allows us to control our risk-reward balance. (I’ll get into that in the money management pages.)
WHY TRADE WITH FIBONACCI LEVELS?
Day after day, week after week, Fibonacci retracement and extension projections are used by individual and institutional traders alike. Yet, I’ve even heard a struggling trader claim that he ran a “test” that proved Fibonacci levels are no better than a coin toss for predicting future prices.
That may technically be true… but guess what: some of us are using it to grow our accounts at rates that hedge fund managers only wish they could (not because they can’t but because of other issues that I won’t bore you with here.) Why? Because we don’t always need to predict future prices to make money — it just helps to have a road map to where and when price is likely to continue (and where it’s likely to stall and reverse.)
So what’s so special about Fibonacci retracement and extension levels?
Every day, trillions of dollars change hands on the Forex markets — mostly in pairs like the GBP/USD, USD/JPY, and EUR/USD (in other words, the major Forex pairs.) Cue the record-scratch sound effect. You’ve probably heard this spiel a million times from online Forex brokers.
Yes, it’s true, but did you know that the great majority of those trillions of dollars are traded by a few major banks? (That’s “few”, compared to the millions of small banks around the world.) These major worldwide banking institutions, called Tier 1 banks in Foreign Exchange jargon, are essentially the hands that move the markets. Major Forex pairs like GBP/USD (British Pound vs US Dollar) and EUR/USD (Euro vs US Dollar), often touted as the most liquid pairs in the currency trading world, are essentially driven by the combined decisions of traders at the Tier 1 banks and the client orders that they put through.
In case you were wondering what I meant by “liquid” — that just means that there’s always someone out there to buy when you’re ready to sell, and vice versa. And now you know why.
Now, you might argue that these Fibonacci retracement and extension levels are really the result of all their client orders netted together to create a natural phenomenon… or maybe the Tier 1 bank traders themselves believe in these levels, and therefore cause them out of a self-fulfilling prophecy, as I mentioned in the introduction. You can choose to believe one or the other, it doesn’t matter as long as your belief doesn’t affect your trading decision making process.
What matters is that these levels provide us with something every trader wants: Predictions.
WHAT EXACTLY DO FIBONACCI LEVELS PREDICT?
You might be wondering: Do Fibonacci retracement levels tell me how far price will pull back? Will Fibonacci extensions tell me exactly where price will continue to?
Actually, no. And that’s actually not what we need them for.
See, the value of these price “zones” is that they give us a better than 50% chance that price will stall when if and when it reaches these zones. Allow me to emphasize that: if and when, not just when. We don’t need to know that price will for sure reach these levels in order to make profits. All we need to know is that, if the market pushes the price of a currency toward one of these “zones”, the highest odds of stalling is less on the way there and more when it actually reaches there. Neither one is a guarantee, just a better than 50% chance… and that’s all we need to make real money.
As I’m typing this, I feel like a lot of it comes across vague or generalized. I guess I just can’t explain every detail of every concept I mention in this introduction without branching off into a million tangents, so expect to see some detailed elaborations when I get around to them in the (more in-depth) pages on this site.
For now, all you need to know is that after the market has made a swinging move (in either direction), there are opportunities to use the Fibonacci retracement and extension levels to predict where it will most likely stall in the near future.
When would you need such a thing?
Well, imagine that you’ve already entered a trade going long (you bought, ie. you’re betting on its price going up) on GBP/USD. For the purposes of this example, it doesn’t matter how or why you entered, only that you already have. Now, one of your biggest problems might be that you’re worried you might take profits too early or too late. What if you hold on to your entire position and watch as it turns around and slams you into a losing trade. Or, worse, what if you take the entire trade off the table, only to watch as the market continues in your direction for another 5x your profit.
Using Fibonacci retracement and extension levels, you can better predict where price is more likely (more than 50/50 odds) to stop — and when price is nowhere near a level, you can place confidence (more than 50/50 confidence, of course) in the likelihood that price might still continue.
(In reality, I would never leave my profitable trades to chance as much as the above example implies. I’m just using that to illustrate the basic idea behind the use of these price “zones”. In a real world trade, there are other factors that could help us kill two birds with one stone. I’ll explain more in the strategy pages.)
It’s not a magic wand for Forex profits… but it’s one of the most invaluable tools in the arsenal of profitable Forex traders. It’ll help you make better decisions (or at least help you plan better profit targets for your trades.) Learn to use them.
Continue to Fibonacci Retracement Basics…
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Fibonacci Retracement Basics
I’m going to start off with a very elementary look at the principles of Fibonacci retracement analysis. This, by itself, isn’t really a trading method; it’s just a way to analyze the recent price action so you’re better equipped to make decisions. (I’ll cover the actual entry and exit strategies, and other analysis methods that I use to backup my Fibonacci retracement analysis, in the Trading Strategies pages to come.)
Note: The following MetaTrader screenshots and explanations are here to illustrate the basics of Fibonacci retracements. They’re not intended to show any actual trade recommendations (They’re also long past, so unless you can time travel, it’s too late anyway.)
STEP 1:
Pictured in this EUR/USD chart (above), we can identify points A and B as the last major swing low (A) and swing high (B).
Notice that, at point C, the market failed to make another higher high. This is why I would choose this moment to consider using the most recent swing (that move from A to B) for our retracement analysis. As always, there’s a good chance even I could be wrong about this (the market might just re-test the resistance level at point C and break it — in other words, it might just continue upward without retracing much) but if I am, no harm would be done as long as it didn’t trigger a trade.
Remember, this is for retracement analysis right now (the process of looking for what might happen; NOT a time to start “assuming” anything will happen — keep that difference in mind.) This is NOT a reason to jump into a trade yet, it’s just a reason to begin drawing with the Fibonacci retracement tool in the next step.
NOTE: For those of you who already know a little about Fibonacci retracement: This scenario was chosen to illustrate a point, but for the readers who asked about the choice of highs and lows… I would choose point A and point B (as shown) because those are the most recent “unbroken” peaks on the chart (the market hasn’t gone below or above them during the course of this recent short-term trend.) This is actually a 15-minute chart, so realistically, there wouldn’t be any smaller swings that would be of any real significance. If you were doing this with a 1-Hour chart or above (which does work too), there might be some extra opportunities along the way.
For the beginners, you can ignore this note for now and just try to grasp the basic idea of finding the low and high of a swing in price action.
STEP 2:
Find your Forex trading software’s Fibonacci retracement tool. In MetaTrader (pictured), look for the little “F” icon with the dotted lines (highlighted in the picture, above). Click it.
Note: I’m using MetaTrader as the main demonstration tool because it’s still the most popular platform for online forex trading. Obviously, there are quite a few alternatives out there, but most of them are either unique to a single broker (developed in-house) or designed for institutional accounts that most beginners just won’t realistically have access to (yet.) Still, if you’re using any popular Forex broker that uses their own proprietary trading platform (like OANDA’s FXTrade or FXCM’s Trading Station II) then it shouldn’t be too hard to find your software’s version of the Fibonacci tool. They all have it, it’s just a matter of how and where to access it. (Check the platform’s help pages if you really can’t find it.)
STEP 3:
Using the MetaTrader platform (as pictured), you click and hold on the bottom of point A and drag your mouse to the top of point B. If this were a down swing (ie. A would be the top and B would be the bottom), then you would drag from top to bottom — either way, you would still start from left to right.
In some trading platforms, such as OANDA FX Trade, you don’t drag the mouse. Instead, you would just click on A (click once) and then click again on B, and the result should look essentially the same. Once you get past these minor differences between the different platforms, you’ll find that the Fibonacci tool will ultimately show you the same information.
And yes, you’ll find it in most of the decent stock trading platforms too. (Probably not the lackluster web-based ones but if you have a decent “active traders” broker like Interactive Brokers, you can find most of the same tools.)
STEP 4:
And there you have it. EUR/USD (Euro vs US Dollar) retraced past four of the major Fibonacci retracement levels (D, E, F, G) before stalling and possibly re-testing the swing high (B).
PRACTICAL NOTES:
If you’re wondering how this could actually be used in the real market, imagine that you decided in Step 3 to trade a “counter-trend” move toward the 50% (F) or 61.8% (G) retracement zones. You would use the swing high (B) as your stop loss. As you can plainly see, either of the two targets would have given you a decent risk-reward ratio since they would both be larger than your stop loss. In a worst case scenario, you would get stopped out and have a choice to reverse your position to follow the trend of the original up-swing (A to B).
Again, this strategy for entry and exit isn’t the point of this article. I just wanted to illustrate a basic way of looking at retracement analysis and Fibonacci trading in general. In the articles to come, I’ll get into more of the juicy stuff as far as actually using these scenarios to your advantage.
Remember, it’s all about stacking the odds in your favor, whether you’re Fibonacci trading or just scalping round numbers. Fibonacci retracement analysis is just one of the tools in your arsenal.
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Money Management for Currency Traders: An Introduction
Some might say that trading is a form of gambling. Now, that can mean one of two things to you.
Either you’re a gambler in the sense of the typical emotionally-driven adrenaline-seeking sucker, whose every thought pattern and decision was already predicted by the design of the casino (and the loss of your money is almost guaranteed before you even choose a table or slot machine)… Or you’re the kind of professional who might get kicked out of the casino and banned for life, for being one of the select few who are actually able to make money — and keep it.
In the currency trading world (and futures, options, and stocks for that matter), the suckers are already a dime a dozen. Or make that a mini-account-a-dozen, maybe.
If you’re serious about trading to make money, then it’s time to stack the odds in your favor. Always keep in mind that what you’re naturally inclined to do… probably will cause you to lose money in the long run. So fight your natural (and predictable) instincts and learn to keep your profits.
The first step is to learn to manage your account balance like a pro.
TRADE FOR SURVIVAL
What good is making a thousand tonight if your methods are more likely to cause you to lose two thousand tomorrow night? If you’re looking for a lottery ticket, they’ve got cheaper ones for you at the convenience store. If you want to build your equity and grow your wealth, then learn to trade for the survival of your account.
Risk between 2% to 5% per trade, at the very most. Some have gotten away with more, but their risk of ruin is also a lot higher when that eventual dry spell comes along. No one is perfect, not even the hedge fund managers on Wall Street, so don’t assume you can trade with a perfect track record. Prepare for the worst so you can survive the storms to come.
The drawback, of course, is that the less you risk, the less you can potentially make at once. I realize that most beginners are probably saying to me, “that’s easy for you to say! If I had an account with a balance like yours, I’d be happy risking 2% too!”
Believe it or not, I remember what it was like starting with a micro account with a balance of less than $1000 USD. The thing you need to drill into your head, though, is that I never made that work for me either until I accepted that I needed to treat the first $500 as if it was a huge account already.
Think in percentages, not dollars/pounds/euros (or whatever your native currency is.)
Aiming for 3% to 5% per day right now might sound like pocket change, but if you can become consistent enough to do that on a regular basis (and balance it out with losing days that are 2% or smaller) then you would have the potential to grow your account into a half-million or more. Remember, it’s all about compounding — even if you withdraw parts of your profits for short term use.
THE RISK-REWARD CONUNDRUM
As a serious trader, you need to drill into your head that there’s no way to avoid losses altogether. It won’t happen. No one on Wall Street or in London can do it even with decades of experience, and teams of researchers. In fact, it’s not a prerequisite to making (and keeping) profits in the markets. The only prerequisite is that your losses must always be, on average, smaller than your gains — over any given period.
(In some trading styles, larger risks are taken to gain smaller but more frequent profits. These methods are generally used by scalpers who shoot for high probabilities. As long as the winning trades are frequent enough, the net effect is the same as saying that any given set of ten trades always has a smaller loss than the average set of ten winning trades’ profits. As a beginner, it’s near impossible to shoot for a technique like this so don’t try it yet. I hesitated about mentioning this at all, but for the sake of providing information that’s more complete and real than most of what’s out there these days, I decided it’s worth mentioning for some of the more advanced readers.)
Here’s the main problem faced by most traders: If you try to trade with stop losses that are always smaller than your profit targets (good risk-reward ratio, in theory), you end up being more likely to get stopped out even in trades that end up hitting your target.
It’s a balancing act. You can’t expect to find a way to eliminate all scenarios like that, but you can try to optimize your method to avoid it as much as possible — that’s where the experience and technique comes into play. (I’ll get into this in more detail as we go deeper into this section.)
To elaborate: Imagine that we always trade with a 5 pip stop loss and a 10 pip profit target. In theory, this is a good risk-reward ratio (every winner, 10 pips, is twice the size of every loser, at 5 pips.) The reality is that the market, with all else being equal, is more likely to swing 5 pips in both directions before hitting your 10 pip target.
(Note for advanced readers: To be fair, some of the same strategies used on much larger scale — say, for example, a 200 pip stop loss and a 500 pip target — can actually avoid some of these pitfalls because that 200 pip stop can be placed very safely behind a long-term support or resistance zone. For the beginners, this will become clear as you learn — for now, it’s just something I wanted to mention for readers who might object to my over-simplified 5/10 example above.)
Before I end off this introduction to money management, it’s worth hammering in a point that far too many beginners seem to overlook…
THINK PERCENTAGES, NOT PIPS
For the sake of illustration, let’s say you trade two styles: A daily breakout that relies on a morning range, with stop losses between 20 to 40 pips; and a longer term technical analysis method, based on daily or weekly charts, that have stop losses between 100 to 300 pips.
At face value, to most beginners, the long term method sounds more “risky.”
If you thought so too, then please do yourself a favor and stop trading right now. Learn to position size properly before you touch another live account. Seriously.
With a proper money management method, there’s always a consistency between trades regardless of their time frame and size of stop losses.
(In some cases, you might risk more on a trade that you have more confidence in, or some other unique risk management model, but that’s besides the point here — for the sake of this discussion, I’m illustrating just how ignorant it is to assume that a 300 pip stop is always more risky than a 30 pip one. It isn’t by a long shot, but I’ll start with the most basic reasons.)
So for the sake of simplicity (in explaining the concept), let’s say that you’ve decided to risk 2% of your current account balance on each trade — the most commonly recommended risk management method (I said the most common… not necessarily the best for you or me.)
If your account balance is $2000 USD to start, then 2% risk is $40. So, as of this given moment, your maximum risk per trade would be $40.
Trade #1 — the one with a 30 pip stop loss, 60 pip target
40 / 30 = 1.3333
Multiply 1.3333 by 10,000 = 13,333
You need to trade this with a position size of 13,333 units of currency, which is $1.33 per pip.
(Note: In most platforms, 13,333 would be 0.13 standard lots, or 1.33 mini lots or 13.33 micro lots. Either way, you might need to round up or round down. Get into the habit of rounding down in situations like this, because that $40 risk might end up being equivalent to $4000 or more to you some day.)
Trade #2 — the one with a 300 pip stop loss, 600 pip target
40 / 300 = 0.1333
Multiply that by 10,000 = 1,333
So you need to trade this one with only 1333 units of currency, which (rounded down) is $0.13 per pip.
The second trade might sound ridiculous to you (it does to most institutional traders too, obviously) but your little 1333 unit trade is actually possible now, with the fractional-mini and micro Forex accounts available on the internet now.
The point is that both trades should do the same thing to your account: If you lose, you lose $40. If you win, you win $80. Yes, that applies to both trades.
The part that you may not realize is that the trade #2 (300-pip risk / 600-pip reward) can actually be less risky than trade #1 (30-pip risk / 60-pip reward).
For example, if trade #2 was executed near a very strong support zone that hasn’t been broken in years, so your 300-pip stop is outside of (past) that support and your 600-pip target is within a long-term range that’s been sloshed around a lot, you’ve actually got fairly high probabilities on your side despite the smaller stop loss.
On the other hand, with trade #1 (30 pip stop, 60 pip target), it takes a lot of experience, timing, and a bit of luck, to actually enter a day trade like that and maintain high probabilities. Short term price action can get slammed back and forth by unforeseen spikes and news reactions, or even typical intraday volatility, that can easily take your stop out before hitting your target. (Sure, a spike can hit that stop in trade #2, a few hundred pips outside of an unbroken long term support — but those odds are far, far better in your favor. If you don’t believe me, try trading a 30-pip-stop/60-pip-target method in a demo account for a while, and see how often your stop gets hit.)
Trading is about planning for, and reacting to, a set of “What if…” scenarios. Treat every trade like it might be the last one you can afford to lose — it’ll keep you from making the stupid (and money wasting) mistakes that plague beginner adrenaline junkies everywhere.
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