In our LIVE Trading Webinars each day, oftentimes questions come up regarding how does a trader “know” how far a pair might retrace. First of all, no one knows precisely how far a pair might retrace against a prior move. However, there is a tool that traders can employ to gain a bit of insight on that question.
It goes by the name of the Fibonacci tool.
Take a look at the 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 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 throw 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 A (Swing High) and 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 farther price retraces before it stalls, the greater the likelihood that the pair will drop farther and continue its move in the direction of the Daily trend. We can see here 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.
For those of you who are interested in some additional Fib information along with a bit of its history and rationale, CLICK HERE…