Algorithmic and Mechanical Forex Strategies | OneStepRemoved

Trading with the Commodity Channel Index

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When trading, one of the most important pieces of information to have is the ability to identify momentum—when it begins and when it ends. It can help you plan your next trade and to ensure that that trade is successful. It is in the process of charting momentum that the Commodity Channel Index is especially effective, and that is regardless whether you are trading commodities, stocks or Forex.

The rationale behind the Commodity Channel Index or CCI is that it is an oscillator that measures the deviation from the simple moving average over the period. Just like most oscillators, it has an overbought level and an oversold.

In theory, using the CCI is similar to reading a Relative Strength Indicator (RSI). If the CCI is relatively high then the pair is overbought and when it is relatively low, the pair is oversold. In practice, however, using the CCI is a bit more complicated than the RSI. Unless the CCI is calibrated correctly it is practically worthless in identifying momentum cycles. Moreover, without correct calibration, it can generate plenty of false signals. But if you calibrated the CCI well it is an extremely efficient and powerful tool.

Commodity Channel Index: Calibration

The first step in calibrating the CCI is to identify when the current cycle began. This will help us decide the right period in which to run the CCI. In order to identify the beginning of the current cycle we can use Fibonacci Time Zones, which will give us an accurate measure.

For example, when we look at the Fibonacci Time Zones in the weekly chart below, we can conclude that the current cycle started 36 weeks ago. The rule of thumb is to divide the total period by three to give the average a bit more sensitivity. In the example below, it will be 36/3=12 weeks. That is the average the CCI should run on.

The reason we use Fibonacci Time Zones to calibrate the CCI is because the cycle’s length changes from wave to wave as they become longer and consequently the relevant average changes. Through the Fibonacci Time Zones, we can estimate with some degree of confidence when the cycle started.

Commodity Channel Index

Analysing the CCI

Once the CCI is calibrated, the rest is simple. The CCI, as previously mentioned, measures overbought and oversold levels. But rather than just looking at relative highs of the index we need to look at its behavior.

For example, in the Gold chart below, we can see that the CCI is converging with the price movement. That is a clear sign that bullish momentum is fading. If we take it a step further and continue our trend line all the way to the bottom, we can conclude another thing; that is that the pair, in this case XAU/USD, has already peaked and is heading lower in a bearish momentum.

Commodity Channel Index

Another way to chart the momentum is by examining the CCI behavior between the Fibonacci Time Zones. Notice that the CCI has a tendency to bottom out when the cycle ends and then rise. We can use that to ride on a rebound. There are cases, especially on a long term bullish trend, that we can get the exact opposite effect, i.e., the CCI peaks every time a Fibonacci Time Zone ends. The idea is to observe the pattern and then use it to your advantage.

Of course, as I’ve said in the past, oscillators should always be used alongside other indicators to get the full picture, and the Commodity Price Channel is no different. As usual in trading, there are no guarantees, but certainly the well calibrated CCI can provide a very coherent picture of where a pair’s momentum is headed, north or south.

Use Fibonacci Expansions to Set a Limit

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You’re about to ride a bullish trend; you plan your stop loss and gauge how much you can risk. You also know the rule of thumb—that is that your profit should be at least twice the amount you are willing to risk. But how can you know if the trade you’re considering really has potential that is worth twice the risk? The Fibonacci Expansion is a great tool that allows you to assess the potential of a bullish trend, especially when used with other indicators.

Drawing the Fibonacci Expansion

The Fibonacci Expansion on a MetaTrader trend line has three dots yet only the first and third are really worth your focus. The first dot has to be placed at the beginning of the first wave in our expansion wave and the third dot should be placed at the beginning of the second wave.

Fibonacci

Caution: One of the biggest pitfalls in the Fibonacci Expansion is the failure to recognize the second wave. The second wave can only be considered a second wave if it is higher than the first; if it did not create a new high, it’s either not the second wave or, worse, there’s no expansion.

After the Fibonacci Expansion has been drawn, we can see the various levels of possible resistance. It is important to notice that, indeed, the various levels of Fibonacci are acting as resistance levels, especially the 61.8% and the 161.8%. If the Fibonacci levels and resistance levels do not align on key levels, the Fibonacci Expansion was drawn incorrectly.

Setting your Limit

When the Fibonacci levels are overlaid, you can get an indication on possible targets for your trend and can decide accordingly on which level to place your limit. If the limit is more than twice the distance in pips to your stop loss, that is a confirmation that the trade is worthwhile.

Fibonacci

Now you are left with a key decision: where is the potential limit for this trade? That will depend on your degree of conservatism, i.e. your risk threshold. For example, placing your limit at the 200% level is somewhat aggressive. If you have to place your limit on that level to gain twice what you are risking, you are taking quite a chance because there is no margin of safety. But if you set your limit at 161.8% and that gives you twice what you are risking, then there is more margin for safety, and the pair is more likely to fit the 161.8% level than it is the 200%. If the pair surges beyond the 200% level you can repeat the drawing process and stretch a new line and get a new potential target.

Rules to Remember

The biggest risk with Fibonacci, whether it’s expansion or retracement, is that if you stretch it wrong, your entire strategy can go wrong, including your potential target. One way to avoid such a pitfall is to use the second wave rule of thumb. Another way to minimize risk is to calibrate Fibonacci using Parabolic SAR. It is also important to remember that, just like any other trend or support line, the higher you go on the intervals – daily, weekly, monthly – the more accurate it is likely to be (and vice versa, of course). Lastly, and perhaps the most important thing, is the understanding that Fibonacci does not determine trend—YOU must determine whether or not the trend is, indeed, bullish before considering the Fibonacci expansion as accurate.

How to Trade the GBP after Brexit

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The selloff in GBP pairs after Brexit presents a challenge for a trader. At first glance, the strategy for the key GBP pairs, mainly that of the GBP/USD and GBP/JPY, should be simple. The GBP is in vertical short, falling almost in a horizontal line; therefore, the trader should apply a vertical short strategy. But when it comes to the GBP, and for that matter, any pair trading at multi-decade lows, the game plan should be slightly different. So without further ado, here are some tips to trade the GBP after Brexit and any pair that is under its historical lows.

GBP: Two Risks

In the aftermath of the GBP Brexit meltdown, GBP pairs, such as the GBP/USD, have two major risks that we have to navigate around – direction and momentum.

Direction – Since we are talking about multi-year lows, we cannot know when the bottom will emerge, because the pair is in uncharted territory.

Momentum – Again, we have no way of knowing when the momentum will change from vertical bearish movement to a trend to a possible range bound.

So how do we handle those unknowns? We use strategies that minimize the risk from the elements.

Buy on Hammer Reversal

As we can see in the chart below, and as is common when a vertical short occurs, after the vertical short comes a brief bounce. What indicates that that bounce is coming is a hammer reversal candle. A hammer reversal candle is a candle where the middle is long and the opening price and closing price are very close. Once we get a hammer reversal candle we can expect a small bounce.

To increase our confidence in an upcoming bounce we can and should combine a MACD indicator. If the MACD indicator suggests weakening momentum, we get a confirmation. Once we get our confirmation it is a signal to buy; our limit should be set below the opening price of the first full bearish candle of the latest vertical short.

GBP

Why should we use this strategy? When we have no indication as to when the pair will bottom out, it’s hard to take a short without risking a sudden bounce back. Normally, it’s less advisable to trade but, under the current conditions, this pattern gives us a chance to reduce the risk of the unknown and minimize the time we are exposed to a choppy market.

Sell on a Major Pull Back

At some stage, every short, no matter how strong, gets a major pull back. That will be our first real opportunity for a short entry. Once we get a major reversal, and by major I mean at least 38.2% of a Fibonacci retracement, then we will get our opportunity to short. That’s because no bearish trend ends without at least two attempts at the same low. That means that, at such a stage, we are no longer in an unknown and our target is the pair’s lowest point.

It’s important to note that when a pair experiences a major retracement it usually signals the end of a vertical short movement and thus is a signal for us to stop using our hammer reversal strategy.

Our limit is now known, aka the low of the pair. And our signal to short can be varied, as in trading a short under any other circumstance. Oscillators such as the MACD, Average True Range and the Stochastic Oscillator can help us time the resumption of the bearish momentum and ride the bearish wave.

But what’s important to understand here is that after a major retracement, it’s much safer to start trading on a longer term and ride a bearish wave.

In Conclusion

Although those insights have been implemented on the latest meltdown in GBP pairs, the tactics we learned here are not only useful for the GBP but can prepare you for the next FX pair meltdown, whether it’s the Euro pairs or the Brazilian Real pairs. What those tactics teach you is how to trade a rather risky situation with plenty of uncertainty. Sure, it is still risky to trade a currency in a meltdown, but at least, with the tactics above, you can avoid the major pitfalls.

Beware of a Fake Trading Signal

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How many times were you certain of that one trading signal that told you that a trend was over? Or what about the one that indicted a trend was just about to begin?  Of course, that “prophecy” was eventually dispelled and the market turned against you. It probably happens quite a lot, maybe even more than you’d care to admit.

Those are fake signals. That’s when you think you’re getting a clear signal, but… you aren’t. Sometimes identifying a fake trading signal can be tricky.  Often, a little alertness can save you the pain of following the wrong trend. In this article, I will focus on some tips that will allow you to avert some of the more common fake signals.

Moving Average Fake Trading Signal 

This is a classic fake trading signal. The Moving Average Cross, where the fast moving average crosses the slow moving average, signals a trend change. For this example, let’s look at the chart below. When the fast moving average (blue) crossed above the slow moving average (green) the trend didn’t change. In fact, the fast moving average later crossed the slow a few more times.

Fake Signals

Source: esignal

How Can You Avoid this Tricky One?

You must validate the change  of trend signal with another trading  signal. For example, in our sample, the pair had not broken the 1.17 resistance that caps the pair in bearish territory. We can’t expect a trend to be changed before the resistance that trims that trend has been broken.

Another helpful tool would be to move one level up and run a long term EMA. In the case of weekly, 52 weeks is the most effective in giving a general indication of momentum. Again, it’s not definitive by itself.

First you need to determine if the moving average cross suggests a changing trend. Then, see if key resistance has been broken. If both have, then the pair should also trade above its 52 week EMA. As we can see, those conditions were not fulfilled. The combination of the supplemental conditions should lead to one conclusion. That is that trading signal was, indeed, a fake moving average cross signal.

Trading Signal

Source: esignal

The Fake Double Bottom 

The second most common fake trading signal is the fake double bottom. The Double Bottom is a classic signal traders often rely on. When you see the pair forming that classic M shape you instinctively take the opposite trade. Then you ride out the counter bullish trend. After all, if this is a bottom, the pair can only go up right?

But as is clearly shown in the chart below, the trend didn’t change. And after reaching the shoulder (see chart) the pair flipped again into bearish and broke the support.

How to Avoid this Trap

In order for the double bottom M shape to confirm a trend change the pair must close above the shoulder. If it doesn’t, the trend is capped on a bearish momentum. Then the likelihood for the trend to continue with its bearish trajectory is high. A close above the shoulder, however, is a good validation that the trend is bottoming.

Fake Correction

This is another classic; you get a trend line broken(in blue) and immediately conclude that the trend is going to flip. Of course, you jump on the band wagon and open a short. Later, you encounter a brick wall at support and have the bullish trend resume.

Trading Signal

Source: esignal

Once again, my main tip here is to go one level up. Now you can see the broader channel and clearly see that we are still within the trend. That way you save yourself from a false entry.

Trading Signal

Source: esignal

Fake Fibonacci

Closing out our list is a pure classic: the fake Fibonacci trading signal which is support that you mistakenly rely on. This is usually driven by human error of stretching from the wrong points.

How to avoid the Fake Fibonacci?

The Parabolic SAR is very effective at this. Luckily, this is a subject we’ve already covered and you can read all about it here.

In Conclusion

There are many, many more fake signals and an equal number of ways to identify them. The problem is very often you won’t be able to spot the fake. But at least, with these basic rules of thumb, you’ll get an edge up. If you can spot the obvious ones you can improve your statistics and your odds. And trading is all about tilting the odds in your favor.

Enhance Fibonacci with Parabolic SAR

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If you use Fibonacci retracement on a regular basis, this article is for you, because for all their simplicity and convenience, Fibonacci levels have one tricky element that every trader who uses them has to figure out. How do you decide where to start measuring your Fibonacci retracement? If you start from the wrong point, it has implications for how useful your Fibonacci level is. So is there a trick to getting the right Fibonacci levels? Yes there is, and it involves the Parabolic SAR, the lesser known brother of the Relative Strength indicator.

How Parabolic SAR Can Help You

The Parabolic SAR is an index developed by the same mastermind who brought us the Relative Strength indicator: J Welles Wilder. It is commonly used as an effective tool for trailing stop losses. However, the Parabolic SAR also has another very good use: it is very effective at identifying pivots. As seen in the weekly chart below, as the Parabolic SAR switched from being above the price (a bearish sign) to being below the price (a bullish sign), the pair – in this case, the EUR/USD – reached a pivot. And, of course, the converse is true – when the Parabolic SAR switches from being below the price to above it, this is also a pivot.

So why is this indication so valuable for Fibonacci? Basically, a trend lies between two pivots of opposite direction. If we know where it started (the first Parabolic SAR conversion) and where it ended (the next Parabolic SAR conversion), we know exactly where to stretch the Fibonacci, making it much more accurate.

A Practical Example of Fibonacci

Once again, let’s look at our pair, the EUR/USD. In the first example, we tried to stretch the Fibonacci from the top to bottom. The Fibonacci levels that we got haven’t really been helpful for us in spotting key resistances and support levels. It actually captured two different bearish waves and this has caused the Fibonacci position to be off. In the second example, we used the second convergence of the Parabolic SAR as a starting point for stretching our Fibonacci because this is the wave relevant for us.

We then used the following Parabolic SAR convergence that signals the end of the second wave as the end of our Fibonacci, or the 1 level. The Parabolic SAR marks where to start our Fibonacci retracement and where to end our stretch of Fibonacci. The improvement in accuracy of the Fibonacci is evident. This essentially means that our Fibonacci levels are much more reliable and can now be trusted as resistance and support levels.

Things You Need to Know

As you have probably guessed, there are some pitfalls you need to watch for/avoid before you implement this useful combination. The Parabolic SAR tends to be more effective on a weekly interval than, let’s say, daily or even hourly. So if you use this method on an hourly or daily basis, don’t expect the same level of accuracy. This probably means that this technical of Parabolic SAR and Fibonacci is best suited for swing traders.

Basic Fibonacci Strategy

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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.

 

Leo Fibo

 

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…

Fib Leo

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,

Richard Krivo

RKrivoFX@gmail.com

@RKrivoFX

Choosing The Right Strategy

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Traders use a variety of strategies in the markets, all based on two forms of analysis: Fundamental analysis and technical analysis. Although institutions and other large traders often use a combination of these two analytical styles, most independent traders rely on strategies based largely on technical analysis.

Let’s take a look at both analytical styles as they apply to trading forex.

Fundamental analysis

In the stock markets, equities traders are sometimes able to value a company (and therefore predict its share price) if they know all the information about that company. That’s because the share price of the company reflects the value of its known assets. By knowing a company, the equity trader knows what its share price should be.

However, in forex markets using fundamental analysis alone is far less effective, because it’s extremely difficult to value an entire country’s economy in order to predict its currency’s value. Most forex traders use exclusively technical analysis.

When full scale fundamental analysis is applied to forex markets, it’s most often used as a way to predict longer-term trends. And, some traders use data such as news releases in the short term to generate trades or confirm signals. So, along with their mainstay technical analysis, some traders incorporate fundamental data.

Here are some of the fundamental indicators commonly used by forex traders:

★ Non-Farm Payroll

★ Consumer Price Index (CPI)

★ Purchasing Managers Index (PMI)

★ Durable Goods Sales

★ Retail Sales

For best results, savvy traders also pay attention to various meetings of government officials and industry conferences, and other venues where market-moving quotes and commentary can be found.

Meetings are scheduled to discuss inflation, interest rates and other issues that directly affect currency prices. These meetings and conferences are often reported in the industry press before they reach mainstream media. The important event for fundamentals-based forex traders is the Federal Open Market Committee (FOMC) press conference and meeting transcript.

Forex traders can follow meetings and conferences and become highly knowledgeable specialists, and profit by knowing a particular market better than most others.

Technical analysis

Technical analysis is by far the most common basis for forex strategies. Using technical analysis in forex is different than in equities, because the forex time frame is 24 hours worldwide whereas many stocks don’t trade overnight, so their price movements are different.

Traders use a huge variety of individualized systems, often built by knowledgeable EA providers, with many different indicators. Here are just a few of the most common indicators and theories used in technical analysis:

★ Elliott Waves

★ Parabolic SAR

★ Gann Theory

★ Fibonacci Numbers

★ Pivot points

Traders craft many different strategies based on technical analysis, especially by combining multiple indicators. Other developers create trading systems based on finding historical buying and selling patterns that are expected to be repeated.

Developing a personal strategy

Successful forex traders develop and fine-tune their strategies over time. Some traders focus on a particular tool or calculation, while others user a broader approach and experiment with a combination of technical and fundamental analysis.

Many new traders wisely start out by “paper trading” or using a demo account with a forex broker. And, experienced traders almost invariably develop new systems with backtesting before trying them in real time. Lack of experience can cause you to lose your capital, so it’s important to take the time to practice before committing significant money to any new trading system.

Regardless of whether you use technical indicators alone, or incorporate fundamentals as well, if you have the discipline to learn your target markets and trade confidently while carefully managing risks, then your strategy has an excellent chance to succeed.

Do you rely on technical indicators? Fundamental indicators? Or, a combination of both?

Fibonacci for Forex Trading

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Fibonacci numbers form the basis of some valuable tools for mechanical forex traders. Fibonacci ratios are especially useful for determining possible support and resistance levels for forex prices in the near future.

Traders like to find high-probability set-ups for trades. Yet, beyond simply trading in the same direction of the current trend, it’s difficult to systematically increase the chance of success without using at least one predictive indicator.

Most indicators are lagging indicators, but Fibonacci ratios can be truly predictive. Unlike the commonly-used lagging indicators, Fibonacci numbers can help make predictions about future price moves regardless of the underlying trend.

Fibonacci indicators seem to be especially effective indicators for trading the EUR/USD and GBP/JPY currency pairs. And, time frames of one day work best for me. Time frames of one hour and four hours will also work, although they require a range of other indicators to show appropriate confirmation.

Fibonacci numbers

I’ve enjoyed good success in using Fibonacci calculations along with a few other carefully-chosen indicators in my mechanical trading strategies.

The significance of Fibonacci numbers

Fibonacci numbers are sequences of mathematically-useful numbers that consistently occur in nature as well as in finance. These sequences are very common in plants – Many trees and other plants form their arrangements of sprouts, leaves, fruits and branches according to Fibonacci sequences

These numbers are named for Leonardo Fibonacci, an Italian mathematician born in the 12th Century. During his childhood and early adulthood in North Africa, Fibonacci learned the Arabic-Hindu numeral system. He focused on performing math calculations using Arabic numbers since they were easier to work with than the Roman numerals (I, II, III, IV, V etc.) being used in Europe at that time.

In 1202, Fibonacci introduced his now-famous sequence of numbers to European mathematicians and scientists, along with a trove of other Indian and Arabic mathematical tools in his book titled Liber Abaci (Book of Abacus, or Book of Calculations).

Fibonacci’s teachings were well-received in Europe. The earliest applications of his work included formulas for commercial accounting and bookkeeping, the calculation of interest, the conversion of standard weights and measures, and other arithmetic tools.

Today, Fibonacci numbers continue to be used to calculate the “Golden Ratio” as well as the “Golden Rectangle,” which are incorporated as a rule of artistic-design proportion for many works of art, buildings and furniture.

Under the rules of the Golden Rectangle, for example, the ratio of the long side of the object when compared to the short side will usually be 1.618 or similar.

This proportion is believed to be very aesthetically pleasing to the human eye, and is therefore often used for design purposes. There are several Golden Ratio proportions, all based on Fibonacci values for their dimensions.

Other uses for Fibonacci numbers include computer algorithms for Internet searches, and methods for connecting distributed and parallel electronic systems. As well, Fibonacci ratios are used by savvy traders in search of predictive indicators.

How to calculate Fibonacci numbers

In mathematics, Fibonacci numbers include the following sequence of integer numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377 and so on. The beginning two numbers may be designated as either 0 and 1, or 1 and 1, depending on the chosen starting point.

Fibonacci sequences show interrelationships: Each subsequent number in the series will be the sum of the previous two numbers. And, any particular number in the sequence will be about 1.618 times the size of the previous number.

Stated mathematically, a sequence Fn of Fibonacci numbers is calculated as:

Fn = Fn-1 + Fn-2 and F(0) = 0, and F(1) = 1

Stated in fractions, for example, the closest rational values used to calculate the Fibonacci Golden Ratios are 3/2, 5/3, 8/5, 13/8, 21/13, and 34/21.

So, when calculating the dimensional percentages of Fibonacci values for integer fractions the values are always around 61.8%, for example:

• Eight divided by 13 is 61.5%
• Thirteen divided by twenty-one is 61.9%
• Twenty-one divided by thirty-four is 61.7%

The Fibonacci ratio of 61.8% represents the Golden Mean or Golden Ratio. This is generally the most-reliable retracement ratio when trading Fibonacci retracements. I program my mechanical trading system to focus on the predictive power of this 61.8% ratio.

The two other Fibonacci ratios commonly used in forex trading are 23.6% and 38.2%, which are often used for purposes of calculating shorter-term retracements, and stop-loss or trailing-stop levels.

During a strong trend, a minimal retracement would be predicted at about 38.2% and during a weaker trend a retracement would be expected at about 61.8%. Of course, a full retracement would be 100%, which would nullify the current move.

Beyond the three retracement levels mentioned above, many forex traders also use Fibonacci retracements at 50% and 100%, which are shown as lines on the chart below.

Fibonacci retracement EURUSD

It’s important not to confuse the different Fibonacci levels. When reconciling a Fibonacci level to the actual price action, be sure to use the same reference points each time for consistency. And, always keep the focus on trading in the general direction of the trend for the specific time period you are trading.

Fibonacci levels in forex trading

In forex trading, Fibonacci numbers help predict upcoming changes in price trends as well as potential retracement, extension and expansion levels. These indicators can be quickly calculated and easily progammed in expert advisor mechanical trading systems.

There are four Fibonacci studies commonly available in charting and trading software – Retracements, fans, arcs, and time zones – and retracements are the most consistent in producing better trading results.

A retracement refers to the tendency of the price of a forex pair or other asset to “correct” after an especially large move. Retracement levels are the price levels to which prices are expected to return after a short-term move contrary to the current trend.

During a retracement, the price encounters an area of support or resistance, and moves from an overbought or oversold condition back toward its current trend range.

Fibonacci retracements in forex trading offer a fairly-predictive indicator of near-future price levels. Fibonacci indicators are effective because, after a significant price move either up or down, very often the new resistance and support prices are near these levels.

On a graphic chart, Fibonacci retracements are shown as horizontal lines that indicate key support and resistance levels. These lines can be shown graphically by drawing various trendlines between extreme values, then dividing vertical distances by the main Fibonacci ratios.

When viewed on a chart, many of these opportunities look like head-and-shoulders and reverse-head-and-shoulders patterns. Best of all, they’re easy to spot using mechanical-trading software.

A well-designed expert advisor can use Fibonacci calculations with a mechanical trading strategy in order to make lightning-fast predictions about upcoming support and resistance levels.

Fibonacci levels for predicting retracements, extensions and expansions

I use Fibonacci ratios to identify trading opportunities and calculate suitable entry points. Fibonacci levels are especially helpful for identifying trades when emerging trends are likely to retrace back to their nearby highs or lows.

In the chart below, the GBP/JPY currency pair’s rate recently fell, then “tested” near the previous support level before once again moving upward. It’s easy to program a mechanical trading system so that trading orders are executed when prices reach Fibonacci retracement levels.

GBPJPY Fibonacci

In the present example, the Fibonacci retracement lines indicate potential levels of support and resistance as the price appears set to continue moving upward. If the trend seems upward, yet the price is below a given retracement level, the next-higher Fibonacci ratio is a likely overhead resistance level.

During a downtrend, the opposite applies – The nearby Fibonacci levels indicate probable support levels at which forex traders will buy GBP/JPY, which may reverse the downtrend.

The most valuable uses for Fibonacci numbers are to determine likely retracement levels in the direction of the current trend, and to determine extension/projection levels in the future. Also, by using three pivot values, Fibonacci numbers can also be used to determine expansion targets for prices, too.

In addition to predicting retracements, Fibonacci numbers can also be used to calculate extensions. Extension levels are the prices which breakouts and other moves beyond the current range are expected to reach.

Stated mathematically, extensions are the moves beyond 100% of the given Fibonacci ratio. The most commonly used levels are 1.00 (100%), 1.272, 1.618, 2.00 (200%), and 2.618.

For example, to find the extension level during a new downtrend, a mechanical trading system will calculate the upcoming new support level at a low-to-high value greater than 100%, since the old support level was breached.

As well, during a new uptrend, the system will run the high-to-low extension in order to determine potential resistance levels; these can be used as profit targets or trailing stops.

The third main way of using Fibonacci numbers in forex trading is to calculate expansion price levels. Expansion price targets are determined by using three price points instead of two as used for calculating retracements and extensions.

For example, to determine expansion price levels for “buys,” the mechanical trading system uses two major lows and one major high in order to calculate resistance. To calculate target support levels for “sell” positions, the system uses two major highs and one major low price. The most common price levels used for expansions are 1.618, 1.00 and 0.618.

Risk management and volatility

The longer the time period used to signal the trade, the less will be the risk from general volatility. Retracements over short time periods are less reliable than those over longer periods. As indicated above, I prefer to trade based on daily price data instead of hourly or four-hour numbers.

Volatility can greatly affect short-term pricing. It may skew resistance and support levels, and cause whipsaws and spikes. It may seem difficult to determine which level of Fibonacci retracement should rule the expert advisor’s actions.

Setting the rules for stop-loss and trailing-stop orders requires caution – Short-term retracements may be narrow. If used carefully, Fibonacci retracements can be used to set stop-loss limit orders.

As an example, if price is trending up and I’m in a long position, my software would place a stop-loss order just below the price’s latest low swing. This may become a new level of price support or recovery, or set a new trading range before the price once again falls through its earlier level of support.

By setting the mechanical trading system’s rules to enter a stop-loss order just slightly under the appropriate Fibonacci retracement level, I can participate in most upward breakouts without overextending risk limits.

In a “short” trade during a downtrend, the system uses a stop-loss trigger set at a price slightly over the high swing of the retracement, since this is a likely resistance level. By setting the stop-loss orders just beyond the latest far swing, whether long or short, it means the stop-loss order will be triggered only if resistance/support is truly broken.

Likewise, trailing stops can be set using short-term Fibonacci retracement levels. The potential retracement levels are calculated by the mechanical trading system in real time, using the next-lower-order Fibonacci ratios. That way, the trade is closed out when the price move has run its course, but while the trade is still profitable.

As for position size, I use no more than 2% of account equity for each non-correlated trade. And, my mechanized trading system allocates no more than 1% of equity to each of two correlated trade opportunities, for example, two concurrent trades in correlated currency pairs.

I’ve found it best not to rely on Fibonacci-based signals alone. The retracement signals work better alongside momentum indicators. Fibonacci ratios offer reliable set-ups for trades, and I program my mechanical trading system to use other indicators for confirmation.

Short-term trading signals should always be considered in terms of long-term trends. Momentum indicators help confirm that I’m trading in the correct overall direction of the market. As well, you can also use MACD or stochastic oscillators with Fibonacci ratios to confirm entry points.

Fibonacci forex trading

Fibonacci ratios are useful for predicting natural, organic retracement and extension levels for forex prices. When used with momentum indicators and other tools for confirmation, they offer valuable predictive clues about future price movements.

Are you currently using Fibonacci ratios?

Fractals in Forex Trading

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Fractals indicate natural resistance and support levels, which helps to identify good entry points and locate stop-loss points. Most importantly, fractals help me identify trends and ranges.

Fractals can be used effectively in forex trading, especially with the power of a mechanical trading system. Focusing on the EUR/USD and GBP/USD currency pairs gives the best results.

A fractal is a repetitive natural pattern

A fractal is a geometric shape or set of self-similar mathematical patterns found in nature. When broken into smaller pieces, fractal shapes exhibit the same shape or characteristics of the larger object.

In nature, fractal shapes and patterns may be observed in things such as broccoli and many other types of plants, where the smallest florets still have the same overall shape as the largest “head” of broccoli. Likewise, many mineral and crystal forms exhibit similar patterns on both large and small scales.

Price movements in marketplaces are often thought to be random and chaotic. Yet, as with other seemingly-random forms found in nature, fractal patterns can be observed in price charts of forex pairs and other assets. Forex price movements show certain repetitive fractal patterns which can be profitably traded.

Fractals used in forex trading may show the same form at every size scale, or they may show nearly the same form at different scales. Stated simply, in forex trading a fractal is a detailed, self-similar pattern that repeats itself, often many times over.

It’s important to note that these fractal patterns aren’t the regular, geometrically-square figures found in man-made structures; they don’t have sides with even-integer factors. The distinguishing characteristic of fractals in forex trading and elsewhere is their natural organic scaling when contrasted with ordinary geometric figures.

For example, doubling the length of one side of an ordinary geometric square will scale the area of that figure by four, since the square has 2 sides, and 22 equals four. Or, when a geometric sphere’s radius is doubled, the volume scales to eight, because the sphere has three dimensions, and 23 = 8.

In contrast, when the one-dimensional lengths of a fractal are doubled, the space contained within that fractal scales up by a number that is not a whole integer.

Leaving aside the mathematical and technical description of fractals — In essence, I use them in forex trading so that my mechanical trading system can break down larger “cluttered” price movements into very simple and highly predictable views of trends and reversals.

Once these trends are visible, it’s easy for my automated trading system to take advantage of them. In particular, I’ve found that fractal signals based on smoothed moving averages (SMMAs) are very valuable for trading when I use them together with momentum indicators.

How do fractals help with forex trading?

Fractals predict reversals in current trends. When viewed as a set of price bars on a chart, the most basic fractal pattern contains five bars or candlesticks with these characteristics:

1. When the lowest bar is positioned at the middle of a pattern, and two bars that have successively higher lows are located on each side of it, this signals the change from a downward trend to an upward trend;

2. When the highest bar is positioned at the middle of a pattern, and two bars that have successively lower highs are located on each side of it, this signals the change from an upward trend to a downward trend;

Bullish and bearish fractals

Stated differently, when the forex fractal pattern shows the highest high at the center, and there are 2 lower highs positioned at each side, it signals a bearish turning point. And, when the pattern has the lowest low at the center, and there are 2 higher lows positioned at each side, it signals a bullish turning point.

Fractals are lagging indicators, so a mechanical trading system can’t act on them until they’re a couple of bars into the reversal. Still, since most of the significant reversals last for multiple bars, the trend usually continues long enough for me to trade it.

Fractals work best for forex trading when used together with a momentum indicator. Along with fractal indicators, I also use an oscillator such as the CCI indicator to facilitate entering a forex trading position as early and safely as I can.

Fractal Alligator indicators

My favorite fractal tool is the “Alligator indicator,” which is a moving-average tool that relies on fractal geometry and SMMAs. This indicator with a fancy name was introduced by senior trader Bill Williams around 1995, and it’s commonly available in MetaTrader software.

If you’re using MetaTrader, you should be able to easily add this fractal indicator by clicking on the menu tabs “Insert,” then “Indicators,” “Bill Williams,” and “Fractals.”

Alligator indicator lines confirm the direction and presence of a trend. Specifically, the Alligator indicator consists of 3 smoothed moving averages. Overlaid on pricing charts, these balance lines represent the metaphorical “jaw,” “teeth” and “lips” of the Alligator.

Carrying the metaphor further, it can be said that when the 3 balance lines are intertwined or converged, the Alligator is asleep with its mouth is closed. This indicates that particular forex market is trading in a sideways range.

Once a trend forms, the Alligator awakens and it begins to “eat.” The Alligator isn’t a picky eater; it can feast on either a bull or a bear. Once satisfied, the Alligator’s mouth closes and the creature returns to sleep.

The Alligator fractal indicator shows trends in the following way: When the price is trading above the mouth of the Alligator, i.e. the green balance line is over the red line which is over the blue line, and all three are aligned and pointing upward, yet still below the price line, this indicator signals a clear uptrend.

Conversely, when the price moves below the Alligator’s mouth, and the blue line is over the red line which is over the green one, and all three of the balance lines are above the price line, then the indicator signals a downtrend.

Finally, once the fractal forex trading Alligator has sated itself, the green, red and blue balance lines once again converge and cross over, signaling the end of the trend. At that point, my mechanical trading system takes profits, and then begins to watch for the next fractal forex trading opportunity.

In short, my mechanical trading system filters fractal signals by stating that the buy rules are confirmed only if they signal a value below the “alligator’s teeth” in the pattern, which means the center average.

Likewise, my sell rules are only confirmed if they signal above the alligator’s teeth. As well, I double-confirm the validity of Alligator signals by using the CCI oscillator.

Fractal forex GBPUSD

The fractal Alligator formula

The Alligator’s jaw, often depicted as a blue line, shows a Smoothed Moving Average containing 13 periods; this line is then moved 8 bars into the future;

The teeth, depicted with a red line, shows a Smoothed Moving Average containing 8 periods, moved 5 bars into the future;

The lips, depicted as a green line, shows a Smoothed Moving Average containing 5 periods, moved 3 bars into the future.

To reiterate, when the red and green balance lines cross over the blue line, it signals my mechanical trading system to “sell.” Conversely, when the red and green lines cross under the blue line, it signals a “buy.”

For purposes of programming a mechanical trading system for fractal forex trading:

  • n is the number of periods
  • High(n) is the highest price during period n
  • Low(n) is the lowest price during period n
  • SMMA(ABC) is a Smoothed Moving Average in which A is the data being smoothed, B is the period being smoothed, and C is the shift in time-period

The mechanical trading system calculates the balance lines:

  • [Low(n) + High(n)] / 2
  • SMMA (Median price n, 13, 8) = Alligator jaw (the blue line)
  • SMM (Median price n, 8, 5) = Alligator teeth (the red line)
  • SMM (Median price n, 5, 3) = Alligator lips (the green line)

Forex markets show many false trends. That is, often a “trend” may appear to begin, yet the price action soon settles back into a sideways range.

When using fractals, my strategy correctly identifies real trends and then follows them. Fractal forex tools such as the Alligator help my mechanical trading system reach through price clutter and focus on finding and trading the real trends.

My fractal trading method based on Alligator indicators

Here’s the simplest form of my fractal trading system based on Alligator indicators:

• Determine the entry point according to when the Alligator balance lines are intertwined, i.e. the Alligator is “sleeping” and when the CCI oscillator is indicating an overbought price condition;

• Execute new orders with 2% of the account equity;

• Places a stop-loss order at exactly 20 pips below the entry point;

• Sets an exit order to be triggered when more than two of the Alligator balance lines cross the candlesticks and/or when the CCI oscillator indicates an overbought condition.

Other ways to use fractals

Fractals are an easy way to see or confirm trends on any time frame. I program my mechanical trading system to check and see whether the fractals are showing lower lows and lower highs, or higher highs and higher lows. For my typical forex trading, I use fractals based on one-day, one-week, and one-month time frames.

The longer the time frame used to generate the fractal, the greater the reliability of the signals it produces. Also, the longer the time frame, the fewer the signals.

Also, I program my mechanical trading system to calculate fractals in order to set trailing stops. Since fractals show changes in trends, they work well to trigger my mechanical trading system to exit from trades when very-short-term reversals threaten to eat up the profits from a trade.

Trading with fractals and Fibonaccis

Beyond using the fractal Alligator indicator, fractal tools offer a great way to confirm Fibonacci signals. I’ve found that fractal forex trading works well when used for Fibonacci retracement levels.

I program my mechanical trading system to draw Fibonacci bands and calculate the fractals using daily time frames in forex markets such as EUR/USD and GBP/USD.

Then, I open a position when the price touches the most-distant Fibonacci band, yet only after my mechanical trading system sees that a daily (D1) fractal signal has occurred. The mechanical trading system exits the trade when a D1 fractal reversal occurs.

When using Fibonacci tools, fractals help pinpoint tops and bottoms with great accuracy. This gives me the confidence to trade at the right Fibonacci level. It’s easy – My mechanical trading system simply looks for the daily fractal parameter.

General considerations when using fractals

In order to double-check the signals generated from fractal indicators, my mechanical trading system uses other indicators such as the CCI oscillator to confirm fractal signals before trading. And, as with any type of trading method, use appropriate risk management measures to ensure that drawdowns are reasonable.

Fractals can be plotted in multiple time frames and used to confirm each other. One simple rule  is to only trade short-term fractal signals in the direction of long-term fractal signals, since long-term fractals are the most reliable. Use another indicator for safety such as the CCI oscillator to confirm the signal.

The Alligator and other fractal tools help

Fractals offer a set of powerful tools that you can use to strengthen your profits. Since mechanical trading systems are able to calculate fractal values and act on them quickly, there are plenty of fractal-based trading opportunities.

My own personal favorite is the Alligator indicator, yet fractals also work well with Fibonacci indicators and other trading strategies. In fact, fractal tools enjoy a relatively small yet devoted following among successful traders.

There are plenty of articles about fractals, as well as trader discussions about the basis for fractal forex trading success if you’d like to explore the topic further.

How do you use fractals in your trading? Share your thoughts on fractals below.

How To Build a MetaTrader Risk/Reward Tool

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The key to trading success is having a solid understanding of the risk your capital is exposed to and how that risk relates to potential profits. That is the reason that we are constantly breaking down how the average annual profit of a strategy relates to its maximum drawdown. In order to understand a strategy, we have to understand how each of its trades work from a risk/reward perspective.

metatrader

Using the Fibonacci tool in MetaTrader, we can create our own risk/reward tool to evaluate trades.

Nial Fuller from Learn to Trade the Market is a strong advocate of risk/reward analysis. In a recent post, he said:

It is critical to understand that most traders who are successful over the long-term are not winning more than about 50% of their trades, but it doesn’t matter as long as they are harnessing the power of risk / reward.

In that post, Nial breaks down the tool he uses to analyze the risk/reward for each of his trades. He provides a simple walkthrough for how to build his risk/reward tool in MetaTrader. The tool is constructed by adjusting the settings of the Fibonacci tool that is already built into the program.

How To Construct The Risk/Reward Tool

In his post, Nial explains that his risk/reward tool is basically a modification of the built in Fibonacci tool. The first step to construct the risk/reward too is to open the Fibonacci tool, then right click on it and go into Fibonacci properties.

The next step is to set a stop-loss level. The distance between the entry price and the stop will define the 1R distance that all of the reward projections will be based on.

After the 1R distance is determined, Nial’s next step is to delete all of the other levels from the fibonacci tool except for the levels that mark the entry and stop prices. Then, the final step is to add profit targets as levels that are mulitples of that 1R distance.

After completing this simple tweak on the fibonacci tool, you will have an overlay that provides you with a visual representation of your current trade in relation to your strategy’s profit and loss targets. This visualization can provide interesting insight into how likely a given trade is to hit whatever reward level your system is anticipating.

Advantages of Using a Risk/Reward Tool

Nial also covers the fact that there are many positive uses for a risk/reward tool like the one he describes.

The biggest advantage is the ability to quickly and visually identify profit targets. In theory, this should make planning trades much easier. The tool will make this process much faster, which will allow a trader to process trades quicker.

The tool also allows the trader to experiment with how adjusting the stop level will alter the profit target levels. It can also be used as a method of filtering out good and bad trades, or as an early exit signal if a trade fails to perform after a certain period of time.