How to define a trend?
The key to successful trading with Fibonacci is to trade in the direction of the main trend. That is why you draw the retracement levels.You want to enter the trade with a better price. You do not want to buy blindly at some random place and guess the direction of the trend. You define the trend, wait for the correction and take a position in the same direction as the trend goes.
If the trend is up, you go long (that is, you buy).
If the trend is down, you go short (that is, you sell).
When there is no trend in place, you do not take any position.
It sounds simple, but it is not that easy to define the correct direction of the trend. Unfortunately, it is necessary to open a position in the right direction to make money. If the trend is up and you go short, you will most likely end with a loss.
What is worse, if you make a mistake and define the trend incorrectly, you might be fooled by Fibonacci, because it works in both ways. Let me show you what I mean. Below you can see the retracement levels and a bounce from 61.8%. Basing on this chart you might think that going long is a good idea.
Unfortunately, going long is a wrong decision, because the main trend is down, which you can see on the bigger chart:
Notice that there is a price bounce from 61.8%, but the main trend is down! You should look for other Fibonacci retracement lines so that you can enter a short position (not long).
You will not be 100% correct every time when it comes to deciding in which direction you should draw the retracement levels and place a trade order. You should have some tools which will help you to recognize in which direction the main trend goes.
There are many tools to choose among, but I will give you some propositions. Test them and choose the one which works best for you.
Look at the chart from a distance
This is a well-known piece of advice and it works. Leave the price only on the chart and zoom out. What is the direction of the trend? You should be able to spot it easily. If not, there might not be a strong trend at the moment.
If you are confused, some say you should look at the chart with the eyes of a child. It is not as silly as it might sound like. Children do not overanalyze things. If something is black, it is black. If the price goes up, then it goes up. Children do not look for some hidden message which other might not know about. Next time, just look at the chart from a distance and try to define the trend at first sight.
On the chart below, the main trend is definitely up:
Identify highs and lows
When the trend is up, the price makes higher highs and higher lows.
When the trend is down, the price makes lower highs and lower lows.
If you are not able to identify these points, there is a chance that the price is not moving in one direction.
This is a simple technique and you just need to practice it. You can start with using a line chart only, as it is easier to read, but in the end, you should use a candlestick chart.
Use the technical analysis tools
You can use the technical analysis tools as help in identifying the current trend. It might be something as simple as the 200 simple moving average. When the price is above that line, you only look for long positions. When the price is below, you only go short.
It is a very simple and yet, an effective tool. Of course, you may want to use a shorter moving average like the 100 SMA. Some traders use an even shorter MA, such as a 50 or 30 periods long. It is up to you.
On the chart below, the price is above the 200 SMA, so you draw the retracement levels only to look for long opportunities.
My set of tools
I personally use the template from Part 8. If you prefer to start with something simpler, try three moving averages:
The 20 linear weighted moving average (typical price)
The 35 linear weighted moving average (typical price)
The 50 linear weighted moving average (typical price)
If the 20 MA is above the 35 MA and the 50 MA, and the 35 MA is in the middle, then the main trend is probably up and I open a long position.
If the 20 MA is below the 35 MA and the 50 MA, and the 35 MA is in middle, then the main trend is probably down and I only open a short position.
If I am not sure what the current trend is (for example, when the moving averages are mixed up), I hold and do not trade.
The importance of the higher time frame
Now you have the tools to enter the position and you know how to manage your position to exit at a good moment. If there is a trend in place and you have correctly identified the direction of the trend, you are halfway to a successful trade.
Next, you have to choose the correct swing to draw the retracement lines, enter the position at the correction and exit at the extension. It sounds simple and it is just that – if you are investing in the right direction.
It may be a huge problem because sometimes the trend is not so clear to see. The trend may be there, but the price action may seem very mixed up to you. Which direction is it anyway? And which swing should you choose? How to avoid confusion?
As a smart person, you probably know the answer, basing on the title of this part. The higher time frame is a vital help.
You have to learn how to use it every time when you are in doubt. Testing the higher time frame is a good idea because it gives you the answers to your questions.
It looks like an uptrend, but is it one? On the 4-hour chart you can see that, in fact, the trend is up after some correction:
That way you get a clearer picture of the current situation.
Remember: if you are not sure about the direction of the trend, check the higher time frame.
There is one more important thing I would like you to remember and use. It increases your chance of success substantially.
The rule is simple:
Always trade in the direction of the trend from the higher time frame.
An example may be very helpful here to convince you to use the rule. Below you can see a 15-min chart of Eur/Usd.
Clearly, there is a trend change and you can spot the correction. When you draw the retracement levels, it looks as if it was working. So, is it a good place to go short?
In order to make sure, we check the higher time frame. Below you can see the same pair but on a 1-hour chart.
Wait a minute! Going short was a bad idea because the main trend is up. That was only a correction. Notice that the retracement levels seemed to fit perfectly. It looked like the 38.2% retracement level was going to stop the price. As I have mentioned earlier, you have to be very careful because the Fibonacci retracement levels work both ways and it is your job to identify the correct trend. In the example, it looked like you should the draw retracement levels for a short position, but the higher time frame gave you an answer not to.
In another example, we look to take a long position at the S&P500 index. On a 1-hour chart it looks like an uptrend, and there is a potential swing where we can draw the retracement levels:
In order to make sure, we check with the higher time frame, in this case, on a 4-hour chart. When you look at the left side, there is a clear uptrend.
The correction ended and new highs were made, which stopped at the 138% extension from that move.
The logic behind this is obvious. The trend from the higher time frame is going to last longer, so it is stronger. When there is a correction, on the lower time frame it looks like there is a change in the trend direction. However, it is not the truth.The correction ends on the higher time frame and the price moves in the previous direction.
Remember about that simple rule and always invest in the direction of the higher time frame. This way, your win/loss ratio will be much higher.
Trading the news with Fibonacci
If you want to trade in the Forex market, you should be aware of the news schedule. Every day there is a lot of economic news from many countries. Most of it is not so important, but there is some news that the market waits for and reacts strongly to their announcement.
If you trade Forex, you should know what economic data will be published. You can check this, for example, on forexfactory.com. In a table on the site, there is a column named impact, which represents the impact of the news on the market.
Some of the most important news is the rate decisions and the non-farm payrolls (NFP).
The US non-farm payrolls are published at 1.30p.m. (London time) on the first Friday of each month.
The US non-farm payrolls release is one of the most closely watched US indicators and is considered one of the best gauges of the US job creation.
The labor market is critically important for the US economy, with unemployment levels playing the leading role in the perceived strength of the current economic recovery. Consequently, the policies of the Federal Reserve may be influenced by the non-farm figures.
Nowadays, all markets are volatile and it is a good idea to trade less or even not to trade at all.
But there is a way you can still trade with good results. The Fibonacci tools are very useful here.
Before I show you how can you trade the news, there will be an important warning.
When you try to enter a position at the time the news is published, there might be a slippage. It means that the difference between the ask and the bid price may be considerable and the cost of entering the position may be very high. Check with your broker what their policy about slippage is.
The advice is to risk only a very small part of your capital for trading the news.
A lot of things can go wrong here, so do not risk too much!
You know the risk now, so let’s see how to trade the news in practice. I will show you a chart from the time when the NFP numbers were released. You can trade on the major pairs or main US indexes. In the examples below, I am going to use the SP500 chart.
The main idea is that the NFP release very often (but not always!) leads to a stronger move. This move is very specific. The first moment after the news release, short-term traders are opening and closing positions – that is why there are a lot of messy moves. We do not want to trade the market like this, so we wait. After the news release, the data is known. Many investors holding back before the release get back to trading. That is why the market starts to trend stronger. Where there is a trend, there are also corrections, and we can use the Fibonacci tools to enter and exit positions.
Look at the 1-minute chart from December 2nd. After the release, there was quite a mess for 5 minutes, but after that time a strong trend occurred.
You can probably see the retracement and extension clearly now. Yes, it is perfect to play with Fibonacci.
My advice is to exit at the extension level. Do not wait too long. When I trade on the news day, I usually divide my position into two parts. I close the first part at the 127% extension line, and the second at the 138.2% or 161.8% extension (depends on the price action).
What is interesting, later that day there was a number of strong moves. It was probably because after data was revealed, investors were taking positions again. You can find a lot of good situations to enter the short term position. For example, later the same day there was another good trade chance. When would you enter and exit?
This was a good day to practice your trading skills. There were a lot of opportunities where you could use the Fibonacci retracement and extension lines, but you had to make decisions quickly – in which direction should you open the trade? This is a very good opportunity to practice, but – again – the risk was greater here! Remember about smaller positions!
Other Fibonacci tools
There are a number of Fibonacci tools you can use. Why is there so much information in this guide about the Fibonacci retracement and extension lines and so little about other tools? It is because I base my trading plan on these tools and they are enough to trade successfully. So should you use other tools? Yes, but there are some things you should be aware of.
Using them all at once may be very confusing and you may end losing money because of information overload. When you draw your retracement, extension, time zones and fan on one chart, you see such a big area of support and resistance that it is simply too much. Do not do that.
It is very important to learn how to use tools like the retracement and extension first in order to be comfortable with them. Then, you can move on and use other tools, such as fan or arcs. You will understand how they work very quickly because the logic is similar to that of the extensions and retracements. You can find the 38.2%, 61.8% and other Fibonacci levels working as support/resistance, so it won’t be something totally new for you.
The advanced guide to fibonacci trading - parts:PART 1. INTRODUCTION
Basic information about Fibonacci numbers and why it is good to know how to use them.
PART 2. THE FIBONACCI RETRACEMENT LEVELS
How they are build and how to draw them to find possible leveles during correction.
PART 3. THE FIBONACCI PROJECTIONS
How to predict where is the best place to exit trade - Fibonacci Extension and Expansion will be helpful here.
PART 4. THE FIBONACCI CONVERGENCE
Learn what convergence is and how to spot it.
PART 5. WHEN TO ENTER A TRADE – A SAFE SCENARIO
Here we put knowledge into practice - you will learn a safe way of opening positions.
PART 6. WHEN TO ENTER – A RISKIER SCENARIO
Little bit riskier scenario of opening trades where possible profit is bigger.
PART 7. WHEN TO EXIT A TRADE
Closing trade is very important, but where is the best place? This should help you to find the best place to exit.
PART 8. MY TEMPLATE
Few examples of different templates you can use in Metatrader software.
PART 9. A FEW IMPORTANT THINGS YOU SHOULD KNOW
How to define trend, the importance of the higher time frame and how to trade the news with Fibonacci tools.
PART 10. FIBONACCI AND PIVOT POINTS
How to combine Fibonacci tools and pivot points.
PART 11. MONEY MANAGEMENT
Proper money management is very important - without it you will be loosing money fast.
PART 12. MORE EXAMPLES OF TRADES
More exapmles where we put together knowledge from guide.
13. THE “HOW-TO” ARTICLES
Few helpful articles about installing templates and using Fibonacci tools.