Add strength to your trading ideas with these…
I think it’s vital to provide you with an all-round basis of knowledge so that you are able to analyse the markets effectively and build a trading strategy of your own.
The more you know, the better, right?
So, today I want to introduce to you something known as Fibonacci retracements.
These can be used to form the basis of a price action based strategy.
I use them sometimes for support and resistance confluence, and to confirm that my trading ideas are right.
Here’s how to use them…
Firstly, in order to draw Fibonacci retracement lines, you really need an indicator to do so for you.
But don’t worry – you should have this indicator on your trading platform.
See the example on the IG platform below, you’ll find the Fibonacci tools in the drawing toolbar:
Obviously, where this tool is will depend on the charting platform you are using, but you should be able to find it as nearly all charting platforms will offer it.
To draw the Fibonacci levels if you are in an uptrend, you simply point your cursor at the starting point of a swing low. This is the lowest low in the range you’re trading in.
You then drag the cursor to the highest recent high available on your chart.
Conversely, if you are in a downtrend you’d point your cursor at the highest high you’re trading in and then drag the cursor to the lowest recent low available on your chart.
See the dotted diagonal line in the chart below for an example:
This will then automatically provide you with some horizontal lines going across your chart – you can see them in different colours on my chart above.
These are the Fibonacci lines. The most important lines to look out for are the 38.2%, 50% and the 61.8% Fibonacci levels.
They indicate areas of support and resistance and movements of the price from the highs and lows.
For example, 61.8% line represents a 61.8% move from the high to the downside (if you have drawn the Fibonacci in an uptrend). The same follows with the other percentages.
The thing about Fibonacci is that there is no real science behind these numbers or levels – like there is with actual primary support and resistance.
The reason why Fibonacci numbers tend to work as a trading indicator is that they are what we call a ‘self-fulfilling prophecy’. That is, it works simply because of convention amongst traders. If many traders are looking at them and using them in their trading then they become real.
This is also why I use it more as confluence, since it just provides strength to my argument to enter a trade most of the time.
Back to the chart above, and you can see that price has recently rejected the 38.2% and the 61.8% (green arrows).
At the same time, you can also see that these levels are key supports… that is, resistance that’s been broken and is now acting as support.
So the fib levels confirm what we are seeing using support and resistance lines and back up our decision to enter a trade.
Can you see how easy it is to apply and use fibs in your trading?
A powerful combination?
Here’s another tool that you can use alongside the Fibonacci retracement tool.
It’s called the 200 Day Exponential Moving Average (EMA) and you can find it on your charting platform just like with fibs.
Take a look at the chart below:
I have overlaid the 200 day exponential moving average (the white line going across the chart).
Exponential moving averages show the average price over the last xx days (in this case 200), with recent prices weighted heavier. What this means is that more recent price activity is given more significance than price activity that occurred 200 days ago.
The exponential moving average provides good price context and can act as support and resistance, or a signifier of a changing trend if it is broken.
Take a look at area I’m pointing at using the green arrow in the chart above…
You can see that there is an intersection here where price moves above the 200EMA.
If tested, a valid strategy could be that if price breaks a 200EMA and tests the EMA and the Fibonacci level, then we buy (if price breaks above the EMA) or sell (if price breaks below the EMA).
Remember, with any strategy it is all about testing and seeing if something works over a large enough sample size.
So give it a go and see how it works for you…