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The forex market sometimes moves in trends and at other times, may move sideways. The trending actions of currency pairs do not usually occur in a straight line. Periods of ebbs and flows occur, just like the waves in the sea. These ebbs and flows correspond to periods that the pendulum of trading activity swings in different directions.
In the financial market, prices can only head in three directions:
- Up, in which case the trend is said to be an uptrend
- Down, also known as the downtrend
- Sideways, also known as a range-bound market or a market in consolidation.
Of these three directions, the only two directions which show the predominance of a group of market players are the uptrend and downtrend.
What Are Retracements And How Can We Trade Them?
In a range-bound market, neither buyers nor sellers of a currency are dominant. On uptrend, buyers dominate the market. In a downtrend, it is the sellers who are pushing the market to the downside. But within these two trends, there are periods when the major market actors pushing the trend take a breather.
Two factors account for this:
- Profit-taking by the traders who entered early into the trend (which occurs most of the time).
- Temporary market reaction to a news release. Whatever the case, those periods when the market takes a breather to interrupt the predominant trend are known as retracements.
Retracements occur all the time, which is why trends do not move in a straight line. As a result, traders must accept retracements and use them to detect possible trade opportunities.
Why Are Retracements Important?
They are important because they mark areas where it is possible to trade re-entries into the major trend. A trend can last for weeks or even months, and not every trader will catch the move early. Therefore, retracements represent an opportunity for the late birds to catch some worms in the market. Traders can use two forex tools to do this. These are:
- Fibonacci retracement tool.
- Fibonacci expansion tool.
It is possible to use both tools to trade retracements in the forex market, using the strategy that is described below.
Fibonacci Retracement: Important Aspects of this Strategy
You have to master certain aspects of the implementation of this strategy so that you can get the best of the trade setups and collect good profits from these trades.
- It is important to demarcate the predominant trend and the retracement area. This requires the use of an appropriate time frame chart. The best chart to use is the Daily chart (D1). This is because this chart is able to showcase price movements over a period of several months. As such, you can detect the actual price direction over time, which makes it easier to separate the initial trend from the retracement.
- Try not to use lower time frame charts, as they paint a false picture of the trend. This is because what may appear as a trend in the shorter time frame may actually be a retracement in a higher time frame.
- The Fibonacci tools require an accurate trace from the swings of price action. In order to do this, you should learn how to use the mouse button of the computer to pin the points of the Fibonacci tools to the appropriate price areas.
- Sometimes, you may require the use of an extra Fibonacci retracement level at 78.6%. You can add this to the mix making the necessary adjustment within the settings of the Fibonacci retracement tool.
To illustrate this setup, we will use the MT4 platform. This is because this platform contains interactive charts and the Fibonacci tools needed for this strategy. You will setup the charts as follows:
- Tools: Fibonacci retracement tool and Fibo Expansion tool.
- Additional indicator: Stochastics oscillator, set to 10,3,3.
- Time frame for chart: Daily
All indicators and the Fibonacci tools used for this strategy are present on most forex platforms.
Fibonacci Retracement: The Trading Strategy
A retracement trade requires patience on the part of the trader and this is because it takes time for the entire scenario to evolve fully. Sometimes, the retracement entry point may stall for days before it finally showcases the setup the trader desires. Consequently, this trade setup suits swing traders the most and are not suitable for scalpers or day traders.
The entire essence of the retracement trade using the Fibonacci tools is to be able to catch the price area to which a retracement will fall back to before the price resumes its initial trend. As a result, this setup provides an excellent opportunity for the late birds to get in on some trend trading action.
The Fibonacci retracement tool is traced from one price extreme to the other when the retracement is in progress.
Why is it done in this sequence?
This allows the 2nd price extreme to form and be visible on the charts. After the trace, five Fibonacci retracement lines which correspond to possible areas the price can retrace to appear on the chart.
Sometimes, a 6th level is added by adjusting the settings of the Fibonacci retracement tool. The correct sequence is to trace the Fibonacci retracement tool from a swing low to a swing high in an uptrend, or from a swing high to a swing low in a downtrend.
With 5 possible retracement areas to choose from, the question is: to what level will the price action retrace to?
This is where the trader has to deploy another tool to mark the exact retracement spot. Consequently, the Stochastics oscillator (set to 10,3,3), which measures the overbought and oversold market conditions, is used to mark the maximal point of retracement.
Set up the trades as follows:
The conditions for a long trade entry are:
- Initial trend is an uptrend with ongoing downside retracement.
- The Stochastics oscillator gives an oversold signal (i.e. lines cross at <25) when the price retraces to a Fibonacci retracement level.
- Execute a long trade by buying at the open of the next daily candle, after the lines of the Stochastics oscillator have crossed with price at a Fibonacci retracement level.
This is a daily chart of the EUR-USD currency pair displaying the setup parameters.
The initial trend is up, with a downside retracement. The reference date for the swing low was July 4, 2013. As at August 19, 2013, the highest price on the chart (swing high) was at 1.34655. The correct trace of the Fibonacci retracement tool from the July 4 swing low to the August 19 swing high is shown on the chart.
While price is retracing, the trader must use the Stochastics oscillator to mark the Fibonacci level which serves as the correct price support for an upside retracement entry.
In this example, the cross of the Stochastics lines occurred on September 5, 2013 when price had retraced to the 50% level. As the bearish (red) candle closed, a new bullish candle opened on September 6, 2013. Consequently, the the open price of this new candle will mark the correct long entry point (See more on candlesticks here).
The profit target should be the point at which the trend is expected to end (See more on trend lines and how to reads them). The tool to use in determining the profit target is the Fibonacci expansion tool.
How is it used?
Plot the Fibo Expansion (FE) tool on the chart by tracing from the swing low to the swing high.
Apply the second leg of the tool to the retracement point of entry. Click the mouse of your computer on the end of this leg and drag it to the entry point of the long trade. This draws the FE levels.
In this example, the Fibonacci Expansion levels were at the FE 61.8% level and the FE 100% level.
Using the Fibonacci Expansion tool provides a degree of reassurance as to the final destination of the current trend before a reversal.
Consequently, there is no need to fear possible reversals occurring and blowing profits away.
The trader should initiate short trade under the following conditions:
- Initial trend is a downtrend with ongoing retracement to the upside.
- The Stochastics oscillator gives an overbought signal (i.e. lines cross at >75) when the price retraces to a Fibonacci retracement level.
- Go short by selling at the open of the next daily candle, after the lines of the Stochastics oscillator have crossed with price at a Fibonacci retracement level.
This is a daily chart of the GBP-USD. The swing high for this trade occurred on December 20, 2015. The swing low (lowest point on the chart) as at January 21, 2016 was at 1.4058. Price retracement to the upside commenced and terminated at the 50% Fibonacci retracement, where the Stochastics oscillator crossed at >75 (overbought). The downtrend resumed from this point.
The re-entry for the short trade is shown at the 50% Fibo level. The re-entry is made by going short at the open of the next daily candle following the completion of the Stochastics lines cross.
Going by the parameters used in setting the profit target, use the Fibonacci expansion tool to trace from the swing low to the swing high. To complete the trace, apply the second leg of the tool to the retracement point of entry.
Click the mouse of your computer on the end of this leg and drag it to the entry point of the short trade. In this example, the Fibonacci Expansion levels visible on the chart was the FE 61.8% point. This would serve as a good point for exiting the trade.
The profit potential for these setups is high. As a result, it is possible to make hundreds of pips from a single trade.
This strategy is good for swing traders; traders who hold positions open for days to a few weeks.
It requires patience and a good steady hand to plot the Fibonacci reference points for trade entry and exit. The strategy is able to deliver good and consistent profits, especially for traders who can exercise the patience required to enable this trade to perform over a period of time.