You probably have heard the old trading adage: when trading in the direction of the trend, it is beneficial to the trader to buy on dips in an uptrend and sell on rallies in a downtrend. I would totally agree with that.
The part that can be challenging when implementing the above, is knowing how far a pair is likely to retrace before it begins moving back in the direction of the dominant trend.
First of all, no one knows with any certainty how far a pair might retrace. However, as traders we can make some educated assumptions.
When it comes to making informed assumptions about retracements in trading, we can thank Leonardo Fibonacci – arguably the most talented mathematician of the Middle Ages.
1170 – 1250
To learn how we can put his knowledge to work in our trading , let’s take a look at the historical 4 hour chart of the GBPCHF currency pair below for an example…
Since the Daily chart on this pair is in a downtrend, we know that we only want to look for opportunities to sell this pair as that would be the higher probability trade. For our example, let’s look at the bearish move that the pair recently made between point A and point B on the chart. Having seen that downside move and then seeing price action begin to retrace to the upside, the prudent trader will be wondering at what point the upside move will subside and stall. They will want to know that because once the pair stalls it is at that point that they can short the pair back in the direction of the Daily trend.
While no indicator or trading tool can offer absolute, unassailable data on when the retracement will end, the Fibonacci tool can shed some light on the situation and provide three levels that the trader can monitor.
By drawing our Fib line in the direction of the move between point A (Swing High) and point B (Swing Low), we can see that the three primary Fib retracement levels are placed on our chart: 38.2%, 50.0% and 61.8%. It is these levels that we will monitor.
(In an uptrend we would draw the Fib line from the Swing Low to the Swing High.)
Ideally, we are looking for a pullback (retracement) to at least the 50% Fib level or, better yet, the 61.8% level. The further price retraces before it stalls, the greater the likelihood that the pair will drop further and continue its move in the direction of the Daily trend. We can see on this chart that price action cooperated nicely and retraced to above the 61.8% level before making a strong move to the downside.
When using the Fib tool, we are looking for price action to stall at one of the Fib levels – the higher the better.
Since in our example we have a couple of long wicks at the 61.8% level, a trader can decide to short the pair at the close of the candle with a stop just above the highest wick.
While this is by no means a fool-proof method for entering a trade, it does provide some helpful information for a trader who is attempting to gain insight on the question of a likely retracement level.
All the best and good trading,