Fibonacci retracement ratios are used as a trading strategy for the Forex market, Futures, Stock trading and even Options.
While the 50% retracement level is talked about a lot, more importantly are the 38.2% and 61.8% but know that in the fibonacci sequence, these numbers do not show up.
We are looking at the 38.2% and the 61.8% (golden ratio) Fibonacci retracement levels for our trading strategy and they come from the calculation of two numbers.
- 38.2% – Found by taking one Fib number and dividing it by the number found two places to the right. Example: 34/89 = .382
- 61.8% – Take one number and divide by the number beside it on the right. Example: 55/89 = .6179 – .618
You can see that the Fibonacci levels we are using are not actual numbers that form in the sequence. They are derivatives of the Fib sequence.
When I was first introduced to Fib levels, I was only focusing on the 38.2 and 61.8% for any trading strategy. Why? The fact is I can put all the levels on a chart and price will bounce from one of them.
By reducing the number of levels used for a trading strategy, I avoid clutter especially when using multiple swing points with the Fibonacci tool.
This came from Joe Dinapoli and since then, I do consider the 78.6% retracement level in some cases such as turning points followed by retests.
Drawing Fibonacci Retracement Levels
The first thing you should do is edit your levels and only show the 38.2% and 61.8% level as those are used in our strategy. Other numbers are not needed at this point as we are keeping this Forex trading strategy using Fibonacci, simple.
On this Forex chart, we are looking to get involved in a market that is moving in a down trend so we want to find a sell setup. To use the Fibonacci tool to properly draw our levels:
- Find an obvious swing high level to begin drawing the ratio
- Find the final swing low before the price rally to end the drawing tool
- The 38.2% level is blown through after briefly holding price
- The 61.8 level holds price and after a few low momentum candlesticks, price breaks
- Note that the 61.8% Fib level coincides with a previous price pause – called confluence
If price is in an uptrend and looking for a buy setup, you would actually start pulling the tool from an obvious low and then up to the right to the final swing high before the retrace in price.
Do Fibonacci Levels Like 38.2 and 61.8 Work?
It would appear that the levels are acting as resistance on this chart (support levels in an uptrend) but understand these are lines on a chart. There is no magic nor do they always “work”. The value I find with Fibonacci retracement levels is that it forces you to pay attention to specific locations on a chart.
As Forex traders, it is easy to be influenced by every move in price but the truth is, not all price is meaningful. Not all price locations are worth trading.
With Fib levels, we are forced into looking at a narrow band of price (traders action zone) and we can then look to see if there is any other technical reason to place a trade.
- Support and resistance levels are a good place to look
- Is there previous price consolidation to the left of current price in the Fib zone?
- Does a moving average line up, within a zone, around the levels plotted by the Fibonacci tool?
Trading fibonacci retracement levels such as 61.8% without confluence is a mistake. Even looking for price action to confirm a change in the short term trend direction makes sense.
Using 38.2% and 61.8% For A Trading Strategy
As mentioned, by using the Fib levels as a proxy measure for support and resistance, we have narrowed our focus down to two locations on a chart.
- 38.2% level would be a shallow rally (retracement) in price depending on the number of swings you are using to connect the Fib tool to
- 61.8% would be a deeper pullback which will give price room to run in your direction before hitting the pivot high or low you used as a starting point
To cover the trading strategy, I am going to use one of the charts I talked about in my free Forex trading setups I post every single week. We are going to look at the GBPAUD four hour time frame chart which will also teach you how to use price action to determine if there is a high probability trading play in the works.
Does time frame matter?
Not really.
The good thing about higher time frame charts is you have less choice which can help you become a more disciplined trader. You may miss setups but often times, like the Forex chart I am using to explain the trading strategy, you can infer what the lower time frames is doing.
Lower time frame charts could help with trade entry when you find a setup. Looking for resumption of momentum in the original trend direction can get you in a trade earlier than a higher time frame such as a daily chart or four hour chart.
Any specific currency pair?
No. Any currency pair can be considered. You may want to look for one that is not in a consolidation unless it already lines up with a 61.8 or 38.2 Fib level.
You can see the momentum push to the downside on both the four hour chart and the daily inset chart. Strong momentum in one direction often leads to another move in that direction. After using the Fibonacci tool to plot our 38.2% and 61.8% retracement levels, we start to monitor price.
- Price pulls back into the 38.2% level giving us a shallow pullback
- Looking left, we see a period of consolidation and after boxing off the area, we extend it to current price. You can see the confluence of two factors but also note the small topping candlestick after the push up. Low momentum
Setup In Play. How To Trade.
Since we are selling a rally, we want to enter a sell stop order below the low of the small candlestick. You can drop even lower (since we did use higher time frame for the levels) to see what price action is doing. We can infer from the high shadow and open and closing price that the lower time frame has settled into a smaller trading range.
By selling the low of the candlestick, we are effectively trading the lower time frame range breakout to the downside. Combined with the confluence of technical factors, the downside momentum on the both the impulse leg and the small range breakout and the high probability of a down trend continuation, we’ve got a high probability 38.2% trading strategy setup.
Stop Loss Placement
Many traders will wrongly suggest placing your stop “a few pips” off the pivot. That is wrong and the sign of inexperience and ignorance of the mechanics of the market. With many different time frame influence due to the massive amount of traders, a retest of highs from lower time frame price action is always possible.
In fact, price can still breach the pivot by “a few pips” and still be a valid setup. That’s called a failure test and one of my favorite trade entries to take advantage of the lack of knowledge by other traders. They are getting stopped out while I am entering or adding to a position.
Feel free to experiment with an ATR stop loss placement or some zone closer to the next Fib level, the 61.8%.
Trade Management
Once the trade is moving, the first roadblock is potential support at the bottom pivot. If risk reward allows it, scale out a portion of your trade here. Keep in mind that the market does not care about risk to reward and holding on for a 1:3 risk reward move when price action is not showing it, is stupid.
I have no problem with 1:1.25 and never worry about 1:3. Ever. That is not something big money traders worry about either.
61.8% Pullback Trade
I mentioned that 61.8% levels show a deeper pullback and when found at trend turning points, they can reap you more pips than you can ever dream about. This next chart is going to show a great confluence (one my favorites) as well as show the 78.6% Fib level that I find useful at certain points in the chart.
As we cover this chart of NZDUSD, consider we’ve been in a strong down trend combined with momentum into lows and price has collapsed into a previous support zone. Price action shows that the bears were losing steam and consideration for a long was made after price began to rally right after breaking lows.
- Price is in our 61.8% price zone with momentum that could not follow through
- We have a former support zone, broken and immediately regain. Note that price at 61.8% is a higher low from the pivot but in line with the higher low to the left
- I mentioned 78.6% Fib levels and I like them at potential pivot turning points that could be a trend change
This was a tough entry because at turning points, price is rarely moving in a great fashion.
Trade Entry At Momentum
The trade entry is off a four hour bear trend line break/retest. For simplicity, you could have:
- Buy stop high of momentum candlestick
- Looked for a small trading range
- Break of highs
- Trend line break off of highs
- Reversal candlestick pattern
Entries are rarely perfect just like our stop loss.
For this trading strategy, when trading a 61.8% bounce, we are fairly close to the pivot and due to the higher swing low to the left of the bottom pivot area, the stop was placed just below that red zone.
Facts About 38.2% and 61.8% Forex Trading Strategy
Using Fib levels as a standalone trading strategy will not prove out with in-depth testing. Ensure you add in confluence factors as mentioned in this trading setup article.
Your trade entries will not be perfect and you may want to consider a multiple time frame approach when it comes to the trade entries. I use that a lot on the setups I post and in my own trading regardless of the market I am looking at.
A great thing about Fib levels is it will ensure you are zoning in on the chart and using small sections to look for trading setups. Support and resistance levels combined with a 38.2% or 61.8% Fib level plus confirming price action is a good technical analysis approach.
Like all trading strategies, ensure you are keeping risk under control and sticking to your trading plan.