Introduction
In the previous article, we understood the definition of Fibonacci and how the Fibonacci levels are derived. Now we shall see how to use these levels to enter a trade and formulate a trading strategy around it.
The strategy we are going to discuss can be used not just in the Forex market. It can also be used in different other markets such as Stocks, Commodities, Cryptocurrencies, and ETFs. This is essentially a trend trading strategy that takes advantage of a pullback in a trend. The Fibonacci levels later prove to be critical areas of support and resistance that most traders keep a close watch on. Let’s get started with the strategy.
Step 1: Identify an initial big move. We are going to trade its retracement.
A trend helps the traders to identify the direction of the market and to determine where the market will head further. A big price movement indicates that the market has reversed from its original direction and will possibly continue further in that direction.
In this example, we have identified a big move on the upside, and we shall see how to trade its retracement to join the trend. Let’s use Fibonacci levels to enter the trend at the right time.
Step 2: Use the Fibonacci tool and plot the levels on the chart
After placing Fibonacci levels on the chart, we need to wait for a retracement and see where it touches the Fib levels. The most desirable condition is when the price bounces off after touching the 50% or 61.8% fib ratio. These ratios are also known as Golden Fib ratios. In the below chart, we can see the formation of a bullish candle as soon as the Red candle reaching the 61.8% level.
In an uptrend, always make sure to plot the Fib levels from Swing Low to Swing High. Likewise, in a downtrend plot, the Fib levels on the chart from Swing High to Swing Low.
Step 3: Enter only after confirmation
Typically, traders are taught to place their buy orders as soon as the price reaches the 61.8% level. Do not do that. Only place the trades after the appearance of at least a couple of bullish candles. In the below chart, the formation of a green candle at 61.8% gives us an additional confirmation that the trend is going to continue after the retracement. Traders can also confirm this buy signal by using reliable technical indicators. This is how the chart would look at the time of entering the trade.
Step 4: Take-Profit and Stop-Loss placement
It is important to place accurate Stop-Loss and Take-Profit orders to mitigate the risk and maximize profits. In this strategy, stop-loss is placed just below the 61.8% Fib level. If the price breaks this Fib level, the uptrend gets invalidated, and we can expect the beginning of a downtrend.
We can place the take-profit order at the nearest’ high’ of the uptrend and trail the stop-loss until it is triggered. The minimum risk to reward of this trade is 1:1, which is not bad. But since it is a continuation of the trend, we can wait until it makes a new high and take profits there. This will result in a 1:2 risk to reward trade.
Below is how the setup of the final trade looks like.
We can clearly see the price respecting the Fibonacci levels, and the trade here went exactly the way we predicted.
Conclusion
Fibonacci retracements are a part of the trend trading strategy that most traders observe during an uptrend. Traders try to make low-risk entries in the direction of the trend using these Fibonacci levels. It is believed that the price is highly likely to bounce from the Fibonacci levels back in the direction of the initial trend. These Fib levels can also be used on multiple time frames. When this tool is combined with other technical indicators, we can predict the outcome of the trade with a greater degree of accuracy. [wp_quiz id=”63028″]
