Perhaps the most attractive aspect of the futures markets is the prevalence of trends. Directional moves in price offer astute futures traders large profit potential in relation to assumed risk. One popular way of identifying and entering trending markets is through the use of Fibonacci retracements.
What Are Fibonacci Retracements?
Credited to Leonardo of Pisa in the late-12th century, the Fibonacci sequence is a mathematical formula with boundless applications. It is comprised of the following progression of numbers: 0, 1, 1, 2, 3, 5, 8, 13, 21, on to infinity. The pattern is simple, as each number in the sequence is the sum of the previous two integers.
Not so simple is the golden ratio (1.618033), which represents the proportionality of one Fibonacci number to another. Fibonacci retracements, as well as a collection of other technical tools, are rooted in the golden ratio.
So, what are Fibonacci retracements? Essentially, they are a set of ratios derived from the Fibonacci sequence used to scrutinize a directional move in price. This is accomplished by measuring the distance from a periodic high to a low and then directly applying the specific retracement ratios to the aggregate value. Below are the ratios included in a typical set of retracements:
In addition to these values, traders often add the 50% and 78.6% retracements to their calculations. While not technically related to the golden ratio, 50% and 78.6% are typically featured within the functionality of automated Fibonacci calculators.
Trading Trends With Fibonaccis
Trend trading is a strategy that aims to secure profit from the momentum driving a directional move in price. In order to be a successful trend trader, one must be able to identify and enter a prevailing trend. This is much easier said than done, as market timing plays a key role in the effectiveness of any trend trading approach.
The good news is that Fibonacci retracements can help in both departments. By viewing price action within the context of segments and fractions, you can effectively identify and enter trends. For instance, a trend may be deemed active or concluded when the following characteristics are exhibited in conjunction with retracement levels:
- Active: A market is considered to be trending when a pullback from a directional move in price (from peak to trough or vice-versa) fails to extend above/below the 38% or 61.8% retracement levels.
- Concluded: In the event that price penetrates the 61.8% retracement level, the prevailing trend is deemed over. The market is then primed to enter either a rotational phase or outright reversal.
This information is extremely valuable in strategic decision making. Here are a few ways retracements are commonly used to trade trends:
- Market Entry: Getting in on a trend can be a challenge. In many cases, traders arrive too late and end up buying the top or selling the bottom of a market. However, by entering a trend after a pullback has occurred, you can achieve an optimal trade location. Common values used for this market entry technique are the 38.2% and 61.8% retracement levels.
- Risk Management: Due to the fact that retracements are viewed as potential areas of support and resistance, they are useful in the placement of stop-loss orders. Closing an open position once a trend proves exhausted is a good way to avoid losses due to market reversal.
- Counter-Trend Strategies: In the event a trend is deemed finished, an opposing position may be taken. This type of approach is especially valuable in reversal and rotational strategies.
The beauty of Fibonacci tools is that they are easily applied in live market conditions. Most software trading platforms include automated Fibonacci analytics via drag-and-drop functionality. However, a word of warning ― using these tools correctly involves judgement. It is subjective to base calculations upon the proper time frame, wave count, and ideal peak/trough values. Often, it takes some experience and education before you find out exactly what works.
Getting Started With Technical Analysis
While Fibonacci retracements are certainly a powerful analytical device, they are not the only technical tool out there. Like most other indicators or studies, retracements are best utilized within the framework of a comprehensive trading plan. Moving averages, Bollinger Bands, and momentum oscillators can also help take your trading to the next level.
For information on these indicators and much more, check out the Technical Analysis Learning Center offered free of charge by Daniels Trading.