January 27, 2011

Trading Fibonacci Retracements - The Pros And Cons

A lot of people enjoy trading fibonacci retracements because they can produce some excellent trading signals, and it is amazing how often the price does actually bounce off these key levels. However I think there is a danger that some traders will end up placing too much faith in them, and will ultimately lose money as a result.

The fact is that there is nothing magical about fibonacci or the main fibonacci retracement levels. The only reason the price seems to reverse around these key levels is because so many other traders all around the world also use the same fibonacci retracement levels on their charts. So as a result it kind of becomes a self-fulfilling prophecy because these same traders will be placing trades around these key levels at the same time, forcing the price to react as predicted.

There are various levels that will show up on your charts. When you plot the high and low points of a recent price move you will be able to see where the 23.6%, 38.2%, 50% and 61.8% retracement levels lie. So in other words if the price of a particular currency pair moves 100 points lower (from the high point to the low point), then it is highly likely to find resistance 23.6, 38.2, 50 or 61.8 points higher before reversing downwards again.

Whenever I use fibonacci myself (which is very rarely), I always use the 61.8% retracement level because I've always found this to be the most significant support/resistance level. However it has to be said that none of these levels are foolproof. Whilst you will find plenty of examples where the price did indeed reverse around these key levels, there will also be lots of examples where the price just went straight through them.

To give you an example, take a look at the 5 minute chart of the GBP/USD pair from earlier today:

GBPUSD_27Jan.png

You can see that after a strong opening the GBP/USD moved all the way up to 1.5943. However it then fell to a low of 1.5880, ie a 63 point move, which is quite significant.

So if you were trading the intraday forex markets using fibonacci you would probably wait for one of the key fibonacci levels to be hit before entering a short position. Let's assume you wait for the 61.8% level which, as I've already said, is generally the most reliable.

If you look at the red arrow, you can see that the price reversed downwards at exactly this point and fell around 23 points, which is a decent move. The price then moved upwards again and tested this level once more. Many day traders may well have been tempted to enter another short position here, but as you can see where I've placed the green arrow, the price just went straight through it.

Furthermore anyone entering short positions at one of the other fibonacci retracement levels will have had little joy because there were no reversals at all around these levels.

So the point I want to make is that fibonacci trading is okay up to a certain point, but I don't personally think that you should trade them in isolation. You are better off using them as a general guide, and using a few other technical indicators, and maybe pivot points if you are day trading. That way you will benefit from the combination of fibonacci levels AND widely used technical indicators, which in turn will help you find lots of high probability trades.

(If you want to learn more about fibonacci trading I can highly recommend these trading videos from Neal Hughes).

 

 

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