Using the 61.8% Fib Retracement

[RichardCox 10]

Using the 61.8% Fib Retracement

 

For new traders, the Fibonacci Retracement is one of the most exotic-sounding terms in technical analysis. In some cases, traders might be intimidated because of this and altogether avoid using the associated strategies. Fortunately, trading with Fibonacci tools is not nearly as complicated as it might sound and once you have some practice with the method, excellent trading opportunities can be quickly identified. The ideas behind how Fibonacci measurements are calculated is based on a sequence of numbers identified by a thirteenth century mathematician, but the applications in modern markets are very real and trading methods using these tools are some of the most popular and highly effective currently used.

 

The main idea behind the strategy is that when major trends are in place, corrections in the opposing direction are inevitable as prices revert to the mean. Since these corrections will actually “correct” the previous price move and reinforce the trend, new positions can be taken on the pullback (in uptrends) or in small rallies (in downtrends). Traders looking for entry points in these corrections typically have a difficult time determining when exactly to go long or short. Fibonacci retracements are extremely helpful in this respect, as the trading zones for new long and short positions are highly exact and measured without much difficulty.

 

Measuring Retracement Levels

 

All of the major trading stations will support the use of Fibonacci retracements as one of its drawing tools for your charts. All that is left to the trader is to identify an important impulsive move from which to base your measurement. This is probably the most difficult part of the strategy, and does take some degree of practice before you will start to get good at identifying these price regions. Of course, it must be remembered that there is no “perfect” answer for which price zone should be used. This margin of error is what makes this step difficult to master.

 

In the first charted example, we can see what a Bull Impulse Move looks like on a real time chart. As you can see, there is very little in the way of downside correction until the area that is marked Corrective Bear Retracement, which is when markets are reverting back to the mean (the longer term average). In the second charted example, the opposite scenario unfolds. Here, we have a Bear Impulse Move that does little to rally until we see the area marked Corrective Bull Retracement, which is where the market is looking to make its needed correction.

 

The most important areas to note in both cases will be the highs and the lows, as this is what will be used to measure the Fibonacci levels. In a Bull Impulse Move, we start plotting the Fibonacci retracement using the lows. In a Bear Impulse move, we start measuring with the Fibonacci retracement tool using the highs. Then, we simply plot the other end of the Impulse Move and our trading stations will plot our Fib zones automatically (usually giving us levels for the 38.2%, 50%, and 61.8% retracements).

 

Plotting Entries

 

Once these initial steps are carried out, we can start to look for price activity that approaches the 61.8% Fib retracement level, which is the most commonly watched price zone in Fibonacci strategies. To be sure, any Fib level can be used as an argument for establishing a position. But here we will be focusing on the 61.8% retracement zone, as this tends to offer some of the highest probability trading scenarios. This is largely because price activity that reaches these areas (essentially giving back more than half of the previous Impulse Move) can be viewed as “bargain prices” within the larger, already established trend.

 

In the third charted example, we can see prices in a clear trending move to the upside. Once this series of higher highs and higher lows has exhausted itself (by posting a lower low), traders should be on the lookout for price action that approaches the 61.8% of the previous bull move. The third charted example shows this in action, and trade entries could be taken ahead of the green arrow, as this retracement level can be expected to contain prices, offer a discount price on the previous uptrend, and offer a signal prices are about to extend higher.

 

In the fourth charted example, the opposite occurs with prices caught in an Impulsive Bear Move. Once prices start posting higher lows, we know that the move has reached its exhaustion point and we can draw our Fib measurements. Once prices approach the green arrow (marking the 61.8% Fib retracement), short positions can be taken as it is unlikely prices will rally much further. In this case, traders are able to get back into the dominant downtrend, but at a higher price when compared to those using breakout strategies.

 

Stop Losses and Ideal Structures

 

In both of these cases, stop losses could be placed just outside of the 61.8% retracement level. The reasoning here is that any violation of the 61.8% zone will invalidate the area as support or resistance that is suitable for trades, and will actually suggest that a full retracement (a 100% retracement) is in store for that currency pair. It would not make sense to hold onto the position until all of that move has been recovered, so it makes sense to cut losses early if the 61.8% zone is later invalidated.

When prices approach the 61.8%, an ideal structure would be one where the level acted as strong support (for uptrends) or resistance (for downtrends). One indication that this is happening occurs when pin-bars form on the approach of the 61.8%. A pin-bar is a candlestick pattern with a long lower wick (for uptrends) or a long upper wick (for downtrends). When this candlestick formation occurs into the 61.8% zone, it is an indication that markets are forcefully pushing prices away from the retracement zone. These types of patterns help validate these retracement levels, and create a higher probability trading scenario when positions are taken.

 

Plotting Profit Targets

 

For profit targets, a lot depends on whether you are a conservative or aggressive trader. Conservative traders will likely want to book profits on positions once the high or low of the previous Impulse Move has been tested. So, for example, if we are dealing with an uptrend and we went long at the 61.8% Fib support level, it would be a wise idea to take profits as prices reach the price high that defined the original measurements. For more aggressive traders, it would make sense to either book partial profits in this region or at least move stop losses to break-even in order to avoid turning a winning trade into a loser.

 

Another less common but equally efficient approach is to use the 61.8% Fib retracement in the other direction -- for placing profit targets to exit your trade. This might seem counter-intuitive but once we understand how Fib retracements operate, the utility starts to become more clear. Since important Fib levels are expected to contain price activity, it would make sense to take profits on contrarian positions once the market has corrected with a 61.8% retracement. So, for example if we are in an uptrend and prices start posting lower lows (a signal the uptrend has ended), we might decide to enter into short positions. Profit targets for that short position can be defined by the 61.8% Fib retracement of the original move, as this would be an area of expected support.

 

Conclusion: Use the 61.8% Fib Retracement to Capitalize on Previous Trends at Better Prices

 

The 61.8% Fib retracement is a valuable tool that allows traders to quickly identify a trend, and then to establish price areas where it makes sense to establish new positions in the direction of that trend. This strategy is preferable to breakout methods because it allows us to buy lower and sell higher on a comparative basis. These strategies can be adjusted to match your trading style (conservative or aggressive), and take relatively little practice to actively master.