4.17 Fibonacci Retracement to Enter a Trade
What’s a retracement? When a currency pair moves X pips in one direction, and then turns around and moves Y pips in the previous direction, we say that there was a retracement (or simply, a pulling back) of Y pips. Putting it another way, a retracement is how deeply the previous move within the trend was penetrated by the correction move. Like this:
On the left, in the uptrend, the trend move is from 0 to A but the retracement is the fall from A to B first and then to C, before the trend resumes. On the right, in the downtrend, the trend move is from 0 to P but the retracement is the rise from P to Q, before the trend resumes.
Swing Highs and Lows
We also need to understand Swing Highs and Swing Lows. This is because your faithful charting package needs you to draw a line through these levels for it to calculate and show you the retracement levels. See the diagram below.
Simply put, a Swing High is a price bar (or, candlestick, if you prefer) having at least two lower highs on its left and another two lower highs on its right. In the diagram above, under ‘Swing High’ you can see what we mean.
Similarly, a Swing Low is a candlestick with at least two higher lows on its left and another two higher lows on its right. In the diagram see the ‘Swing Low’.
How to Trade?
Armed with the above knowledge let’s get into the nitty-gritty of Fibonacci retracements. Just one thing – you get great pips from this method usually in good trending markets, so check the health of the trend first.
So, what’s the plan, you ask. Simply this - get into the trend on a reaction. That gives you a price advantage when the main trend resumes.
We do this in an uptrend by entering a buy order on a retracement at a Fibonacci support level. In a downtrend, we enter a sell order at a Fibonacci resistance level and as you have seen in the previous lesson, these levels are nothing but 23.6%, 38.2%, 50%, 61.8% and 76.4%. Just for the sake of repetition, strictly speaking, 50% and 76.4% are not Fibonacci levels but are included with Fibonacci levels. 50% level is a psychological level that the prices my retrace back by 50% of the gains and 76.4% is derived by subtracting the first retracement level of 23.6% from 100%.
Please also note that when you find the possibility that the price may be going for a retracement, you may take a position against the trend and in the direction of the retracement to target the next retracement level.
OK let’s give a practical blow-by-blow account of how to use retracements in practice.
Retracements during Uptrends
In the chart above we drew the dotted red line connecting the swing low and swing high shown by the red circles, by pointing and dragging the cursor from the lower point to the higher one. The charting program immediately draws in the Fibonacci support lines indicated by the dashed lines and the levels (…23.6, 38.2, 50.0, 61.8….) on the right. The market expects the price to pull back and find support at these levels before it resumes its trend. Obviously we look to buy around these levels so that we hitch a ride on the main trend. See how the price found support around the 61.8 level and then rose up, up and away taking out the earlier swing high. A buy at the 61.8 level sure would have been a great trade!
Retracements During Downtrends
See the Forex chart above. This time we connected the swing highs and lows in a downtrend using the cursor. The software obliged us by showing the retracement resistance lines and the levels on the right. The market expects the price to pull back and meet resistance at these levels before it resumes its downtrend. Obviously we look to sell around these levels so that we hitch a ride on the main trend. See how the price met with resistance around the 23.6% and then just above 38.2% levels and then plunged taking out the earlier swing low. A sell at the 38.2% level would have meant a lot of pips in the bank. The trend was strong and the price failed to complete 50% retracement, however, during strong trends even 61.8% or 76.4% retracements can easily be seen. A warning here – if the price retraces too much, it may indicate the possibilities of a trend reversal also.
One other thing, the Forex market is very deep with millions of players all watching these levels – so one can always assume that there will be some support or resistance around these zones. But don’t assume that these levels are always reliable and bound to give you your share of pips!
Ever so often, Fibonacci retracements fail. What then? See how we protect ourselves in the chapters that follow.
- Fibonacci Retracements in Trading