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Fibonacci trading strategies provide a means by which traders can measure market pullbacks within trending markets, finding trading opportunities in each instance.
The Fibonacci retracement drawing tool can be invaluable for traders, providing the ability to measure partial reversals. This can be particularly useful in trending markets. However, the range of different retracement levels provide a variety of use cases for traders seeking to capitalise on different phases in market price action.
The Fibonacci tool provides a series of levels which measure the percentage a market has reversed between two different points. This means that within an uptrend, traders will typically use the tool to measure the amount of the last rally that has been surrendered, with a view to another leg higher before long.
The Fibonacci tool is applied by placing the two anchor points onto the prior swing high and swing low, utilising the resulting Fibonacci levels as reference points when the market begins to retrace. It is advised to use the absolute tops and bottoms of the wicks rather than the body.
Whether or not a trader believes that the ratios derived from the Fibonacci number sequence are going to provide turning points in the market is beside the point. Markets do not move in a straight line, and thus by studying the size of each pullback, it is possible to recognise where within each market a trader is likely to see each type of pullback – shallow, medium, and deep.
A retracement can be any type of pullback, meaning that the specific Fibonacci levels do not need to be respected for a trader to perceive the move as a counter-trend retracement. Often the respect of those levels will tell us something about the market’s mindset and possible next move.
The shallow pullback is typically seen around the 23.6% and 38.2% level, yet it can be anything shallower too. Understandably, shallow retracements are typically seen within a highly trending or fast moving environment. When a market is moving rapidly in a given direction, we typically do not see enough support behind the counter-move, with any consolidation or pullback often fleeting. The ability to trade around such a move is crucial for situations where a market is moving quickly. Entry into a highly trending market can be difficult given the hurdles associated with setting a stop loss. Typically, it would make sense to place stop losses below the prior swing low in an uptrend, and above the prior swing high in a downtrend. Thus when a market is seeing a strong surge, traders will often jump in without considering the risk-to-reward profile or validity in the placement of their stop loss. However, it makes much more sense to enter a highly trending market within a retracement or consolidation phase. Such consolidation will often provide continuation patterns such as a pennants and flags.
However, what is important is how deep that pullback is, and where the market goes from there onwards. Should we see a shallow >38.2% retracement, followed by a break through the previous peak (uptrend) or trough (downtrend), this would be the signal to trade. The benefit of utilising this method is that it would reduce the likeliness of major losses, while also enabling substantial gains.
The chart below highlights the recent bitcoin sell-off, with a rapid deterioration followed by a shallow retracement. That sub-38.2% retracement provides the basis for a selling opportunity should we see the price break to a new low. As such, the short is opened at $5202, with a stop at $5700 (above the prior swing low). That 500-point stop loss means that we would need 1000 points downside for a 2/1 risk-to-reward (R/R) trade, which was achieved within 36 hours. However, given the possibility for greater downside, it can make sense to take part of your profit at that 2/1 target ($4200), with the rest of the position running to a more profitable target. In such an occasion, you could shift the stop loss for the remainder of the trade to either the break-even point ($5200) or 1/1 profit target ($4700).
Looking for entry positions within deeper retracements is another method of utilising the Fibonacci tool to gain advantageous trading opportunities. Once again it is important to take trades close to your stop loss, with these trades being taken actually at the Fibonacci level itself. Opportunities to take trades at those deeper levels (>61.8%) can come within highly trending markets, but are unlikely to see the same kind of velocity as those markets described for the shallow retracements.
It makes sense that deeper retracements come at points when there are sufficient counter-trend opinions to cause significant pullbacks. As such, some of the most profitable periods can come at the end of a more protracted period of consolidation or retracement. The AUD/NZD chart below highlights the possibility to take trades at 61.8% and 76.4% Fibonacci levels, both within the trend, and in a protracted period of consolidation. Interestingly, we see a sub-50% retracement off the back of the final breakdown from the consolidation seen in the middle of the chart. That inability to post a substantial retracement highlights the fact that swift sell-offs often bring shallower pullbacks.
By placing our stops above the prior swing high, we can obtain an advantageous R/R profile. For instance, a short trade at the 76.4% Fibonacci level, with the stop placed above the prior swing high (100%), would provide a 3/1 R/R ration for a move back into the previous low (0%).
The use of shallow and deep retracements are means by which we can ensure a stop loss which is not too far from the entry level. However, what can we do with a retracement that is neither? Well this is where charting formations can come in handy. Firstly, we have a longer-term trend which tells us a market is moving in a certain direction. When we start to see the market retrace, we do not know exactly how deep that pullback is going to be. As such, it can be advantageous to look at shorter timeframe charts and find patterns that we can base our trades upon. Taking the example of AUD/NZD above, we can look at the 50% pullback mentioned previously.
The hourly chart highlights that we actually saw a rising wedge towards that 50% level ($1.0771), with the breakdown providing a selling opportunity. The $1.0728 level provides the breakdown signal, negating the short-term creation of higher lows. By selling at the break below that level and placing a stop around the 50% retracement, we can once again find a method of selling into the wider trend while maintaining a good R/R profile.
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