In an
uptrend, the general idea is to go long the market on a retracement to a
Fibonacci support level. In order to find the retracement levels, you would
click on a significant Swing Low and drag the cursor to the most recent Swing
High. This will display each of the Retracement Levels showing both the ratio
and corresponding price level. Let’s take a look at some examples of markets in
an uptrend.
This is an hourly chart of USD/JPY. Here we
plotted the Fibonacci Retracement Levels by clicking on the Swing Low at 110.78
on 07/12/05 and dragging the cursor to the Swing High at 112.27 on 07/13/05.
You can see the levels plotted by the software. The Retracement Levels were
111.92 (0.236), 111.70 (0.382), 111.52 (0.500), and 111.35 (0.618). Now the
expectation is that if USD/JPY retraces from this high, it will find support at
one of the Fibonacci Levels because traders will be
placing buy orders at these
levels as the market pulls back.
Now
let’s look at what actually happened after the Swing High occurred. The market
pulled back right through the 0.236 level and continued the next day piercing
the 0.382 level but never actually closing below it. Later on that day,
the market resumed its upward move. Clearly buying at the 0.382 level would
have been a good short term trade.
Now
let’s see how we would use Fibonacci Retracement Levels during a downtrend.
This is an hourly chart for EUR/USD. As you can see, we found our Swing High at
1.3278 on 02/28/05 and our Swing Low at 1.3169 a couple hours later. The
Retracement Levels were 1.3236 (0.618), 1.3224 (0.500), 1.3211 (0.382), and
1.3195 (.236). The expectation for a downtrend is if it retraces from this
high, it will encounter resistance at one of the Fibonacci Levels because
traders will be placing sell orders at these levels as the market attempts to
rally.
Let’s
check out what happened next. Now isn’t that a thing of beauty! The market did
try to rally but it barely past the 0.500 level spiking to a high 1.3227 and it
actually closed below it. After that bar, you can see that the rally reversed
and the downward move continued. You would have made some nice dough selling at
the 0.382 level.
Here’s
another example. This is an hourly chart for GBP/USD. We had a Swing High of
1.7438 on 07/26/05 and a Swing Low of 1.7336 the next day. So our Retracement
Levels are: 1.7399 (0.618), 1.7387 (0.500), 1.7375 (0.382), and 1.7360 (0.236).
Looking at the chart, the market looks like it tried to break the 0.500 level
on several occasions, but try as it may, it failed. So would putting a sell
order at the 0.500 level be a good trade?
If you
did, you would have lost some serious cheddar! Take a look at what happened.
The Swing Low looked to be the bottom for this downtrend as the market rallied
above the Swing High point.
You
can see from these examples the market usually finds at least
temporary support (during an uptrend) or resistance (during a downtrend) at the
Fibonacci Retracements Levels. It’s apparent that there a few problems to deal
with here. There’s no way of knowing which level will provide support. The
0.236 seems to provide the weakest support/resistance, while the other levels
provide support/resistance at about the same frequency. Even though the charts
above show the market usually only retracing to the 0.382 level, it doesn’t
mean the price will hit that level every time and reverse. Sometimes it’ll hit
the 0.500 and reverse, other times it’ll hit the 0.618 and reverse, and other
times the price will totally ignore Mr. Fibonacci and blow past all the levels
like similar to the way Allen Iverson blows past his defenders with his nasty
first step. Remember, the market will not always resume its uptrend after
finding temporary support, but instead continue to decline below the last Swing
Low. Same thing for a downtrend. The market may instead decide to continue
above the last Swing High.
The
placement of stops is a challenge. It’s probably best to place stops below the
last Swing Low (on an uptrend) or above the Swing High (on a downtrend), but
this requires taking a high level of risk in proportion to the likely profit
potential in the trade. This is called reward-to-risk ratio. In a later lesson,
you will learn more money management and risk control and how you would only
take trades with certain reward-to-risk ratios.
Another
problem is determining which Swing Low and Swing High points to start from to
create the Fibonacci Retracement Levels. People look at charts differently and
so will have their own version of where the Swing High and Swing Low points
should be. The point is, there is no one right way to do it, but the bad thing
is sometimes it becomes a guessing game.