Wednesday, 29 March 2017

Lesson 5 – Introduction to Forex Trading - Understanding the basics - Part 2

Fibonacci Ratios

While Fibonacci ratios do not dictate direction, they can often be useful for scaling the size of a price movement in a direction determined by other factors, and as such are often used as support and resistance in much the same way as pivot points.

Simply draw the fib retracement between a major high and a major low in a trend that you expect to continue, and these levels will help determine where the continuation of the trend will be likely to start from once the retracement against the trend has completed.

All trading platforms have the ability to draw Fibonacci retracements onto charts; however there are additional levels you can use, which are outlined below:

fib levels on chart

  • 0% (significant turning point)
  • 23.6%
  • 38.2%
  • 50%
  • 61.8%
  • 76.4% (not standard practice to include this level)
  • 100% (significant turning point)

When trading using fib retracement, it is important to not take a test of the level as a signal to enter a trade. Instead, be on the lookout for other clues that the pair will reverse before entering the trade.
There is no method for a Fibonacci retracement informing the trader that the level will hold, and there are numerous levels that it could turn on if it will turn.

Some general common sense may aid this problem slightly. If a move is particularly strong, it will likely retrace less than a weak move. This is not, however, a hard and fast rule, so look at price action when a level is reached.


Fibonacci Expansions

Using the same concept and trading application as a Fibonacci retracement, the Fibonacci expansion measures the size of a major rally or sell-off, then uses the size of that move and the Fibonacci ratios associated with that price movement and transposes them to the continuation. This means that they start from the place at which the retracement began to continue in the direction of the original move.

In this respect, a 100% Fibonacci expansion level will be two rallies of equal size, with a retracement between them. This is often called an AB=CD and is a good indication of a likely price at which a turning point will occur, should there be other signs which indicate a turn.

Traditionally, their use is slightly different to the way in which they are implemented here, so below are some recommendations for placement and ratios:

Place the fib expansion at the beginning of a new trend.

The points of placement for a new bullish trend should be the recent low up to the high of the first rally and then the low of the first retracement.

Major levels used are: 38.2%, 61.8%, 100%, 138.2%, 161.8%, 200%, 238.2%, 261.8%, 300%.

Minor levels used are 50%, 123.6%, 150%, 176%, 223.6%, 250%, 276%.

Once a trend is mature and these levels are exceeded, rather than replacing the fib expansion elsewhere on the chart, use the most significant (typically the largest) retracement for the entire trend to redraw the fib expansion. This will be likely to result in a much larger fib retracement and allow for much longer projections to be made using the same major and minor levels as before.

fib levels

As shown in the example above, this technique can be used for signalling potential support and resistance further into a trend once it has developed. The top of this chart has a double top at the 100% fib expansion level, which then retraces, only to post another double top at the 123.6% fib expansion level – so clearly the non-standard inclusion of these levels holds some merit.

Confluence of Signals

Confluence of support and resistance means that there have been numerous applications of a technique or various techniques that agree at certain levels. For example, if you applied Fibonacci retracements for a rally from every pull back to the top of the rally, if any of those levels lined up and agreed with each other, then you would have a confluence of fib levels.

AUDUSD chart

Looking at an example makes this much easier. Above is a recent chart of AUDUSD with lots and lots of fibs applied. The chart is quite messy, so it might be frustrating to do this all of the time. But nevertheless, it clearly shows the ability to determine which levels are strong and which may not be so strong merely by relying on the levels that agree on a price.

As another example using fib expansions this time, the bearish fib expansions have been applied to major turning points for the pair. The place at which the 150% fib expansion lines up with the 61.8% fib expansion from the major move lower align happens to have picked a major bottom for Aussie.

AUDUSD bottom

Now clearly, these level choices alone are not sufficient to enter a trade, so you will always want to wait for a price action clue that these levels are going to hold before you enter. In the example of the Aussie bottom, be on the lookout for the old level rejection confirmation friend, the pin bar.

Major Highs and Lows

These are the traditional methods for drawing support and resistance on a chart and can be seen on the charts, drawn in yellow. The simplest method for placing these levels is to move a horizontal line around on the chart, testing all of the major turning points; you will then be able to see prices that are regularly rejected or at least provide support or resistance before they break.

EURUSD Highs Lows

Here is a daily chart of EURUSD with major turning points drawn as support and resistance. The pink dots show where a level has acted as resistance, while the green dots show where a level has offered support.

Round Numbers

Psychologically, 1.5200 will have a bigger significance than 1.5214, so for spot charts and widely traded indexes such as USDX, these levels will act as support and resistance, as will the ‘XX50’ halfway points between them, such as 1.5250. Caution should be taken, though, because traders at banks and large hedge funds know that retail traders like to place their orders here and will occasionally hunt stop-losses by pushing price through these levels to deliberately close a lot of smaller positions.

round numbers chart

The chart above shows round numbers (shown in red) acting as support and resistance, while the XX50 halfway points are also significant. In blue are the daily highs and lows, while green is the monthly high and low. All of these will act as support and resistance if they have not been recently breached.

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