Algorithmic and Mechanical Forex Strategies | OneStepRemoved

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.

Using Parabolic SAR vs MACD

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Parabolic SAR and MACD are both very effective in spotting pivots and yet there is a difference. In some cases, you will find the Parabolic SAR is more effective while in others you might find the MACD more useful. That is why, in order to make the best of both, you must know the advantages and weaknesses of each.

Parabolic SAR has Higher Sensitivity

The first thing you will notice when comparing a Parabolic SAR to an MACD indicator is that the Parabolic SAR signals many more pivots. That is because the Parabolic SAR has, by default, more sensitivity to minor changes. Of course, you can reduce the level of sensitivity, but even so, it delivers more signals than the MACD. The benefit of such sensitivity is that, at times, the Parabolic SAR predicts a pivot before the MACD. But that sensitivity has a downside. In small fluctuations the Parabolic SAR can occasionally produce fake pivots. As you can see from point A to point B, the pair has been trending sideways and still the Parabolic SAR delivered plenty of signals, most are falls. However, the MACD during the same time frame was much more effective.

Parabolic SAR

MACD is better at Momentum

One advantage the MACD has over Parabolic SAR is the measurement of momentum. As can be seen in the chart above, the MACD indicator, through the lows and the highs of its histogram, illustrates how strong the momentum is to either direction. If the histogram falls sharply lower, the momentum is strongly bearish, if it rises sharply higher, the momentum is highly bullish, if the histogram is fluctuating close to 0, the momentum is weak.

While the Parabolic SAR does a good job in identifying the direction of momentum quicker, it is much less effective in identifying the strength of a pair’s momentum. And that is why, when it comes to momentum, MACD is more effective than Parabolic SAR.

Limit/Stop Loss

Another way in which MACD and Parabolic SAR differentiate is in the way they influence stop loss and limit strategy.

Parabolic SAR, being an upper indicator, is overlaid on the price rather than being presented below. The dots of the Parabolic SAR are natural stop loss and limit levels for the short term. Moreover, when used in conjunction with Fibonacci levels, can also be effective in placing long term stop loss and limit orders.

MACD, however, being a lower indicator, i.e. presented below the chart rather than overlaid, has a more complex relationship with stop loss and limits. The MACD can be effective as an indicator for a stop loss when momentum shifts to the other direction, thus pointing to a pivot. But for the MACD to be effective as a stop loss indicator it needs a Gann Fan or an area where the MACD momentum converged more than once, indicating a strong support, or resistance if the trend is bearish.

In Conclusion

Both the Parabolic SAR and the MACD are strong tools for working with pivots, but are different in their effectiveness. One is better in identifying pivots quickly and in placing limits and stop loss, the other is better at analyzing momentum strength and timing entry. Knowing the advantages of each can allow you to optimize the use of both and, more importantly, optimize your performance.

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.

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?