It is frustrating to be stopped out of a trade, even for an experienced trader like me. There are numerous occasions where I find myself stopped out of a trade before I could realise my profits due to inconsistent trade management.
As good practice for any trader, I did a comprehensive review of my trading history and found that 20% of my trades were attempted when the market did not move in my favour, resulting in immediate stop-outs. Conversely, another 20% of my trades reached the target profit I had set. On the remaining occasions, the trades initially moved in my favour before ultimately hitting the stop-loss.
Although it was discouraging, the finding held the potential for improvement. How, you might wonder? The answer lies in Fibonacci retracement. In this article, I will elucidate this tool’s history, the theory behind it and its application in trading scenarios to help readers like you understand how to use the Fibonacci retracement to manage your trades.
History
Before jumping straight into the usage of Fibonacci retracement, it is better to understand the history behind it. For those who might not know, Fibonacci retracement was named after Fibonacci, an Italian mathematician from the 13th century, renowned for his work on the Fibonacci sequence. Sounds familiar? Perhaps the following set of numbers might jog your memory:
1, 1, 2, 3, 5, 8, 13, 21, 34 …
If you have not figured it out, this sequence follows a specific formula, where each number is the sum of the two preceding numbers. For instance, 13 is the result of adding 8 and 5, while 21 is derived from the addition of 8 and 13. This sequence has significant applications in various fields, including trading and technical analysis. The theory behind it lies with another renowned concept, the Golden Ratio.
Often represented by the Greek letter Þ (phi), the Golden Ratio is an irrational number approximately equal to 1.618. It is a mathematical constant that is often associated with aesthetically pleasing proportions and patterns. It can be seen in the dimensions of ancient Greek architecture, famous paintings like the Mona Lisa, and even in natural phenomena such as the spiral arrangement of sunflower seeds or the branching of trees. So how does it link to the Fibonacci sequence?
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Observing the sequence mentioned earlier, the ratio can be derived by dividing the Fibonacci numbers. As the sequence progresses, the result of each division approaches 1.618. In the reverse direction, the result of each division converges to 0.618. This observation has led many to believe that Fibonacci is intricately linked to the Golden Ratio.
As a result, this connection has fostered the belief that the Fibonacci Golden Ratio is a fundamental aspect of nature and because markets are influenced by human behaviour, the stock market tends to exhibit traces of Fibonacci’s influence. The Fibonacci retracement is one such tool that takes advantage of this connection.
Application
Traders employ Fibonacci retracements as a method to pinpoint potential support and resistance levels based on the Fibonacci Golden Ratio. This tool helps calculate the percentage of a price move and the price levels the move tends to retrace back to.
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To illustrate, if a stock has surged by 100 points, a Fibonacci retracement of 50% would denote a level 50 points below the high. Traders hold the belief that these levels frequently serve as areas where the market encounters support or resistance following the Golden Ratio.
I will use the S&P500 ETF as an example (see Chart 1): Since the Fibonacci retracement calculates the percentage of a price move, I will use the ETF’s 2022 price movements by connecting the year’s high and low. Let us observe how prices respond in 2023.
Notice how prices hover, get rejected and find support at these key levels highlighted by the Fibonacci retracement? (see blue box in Chart 1). More specifically, observe how the 38.2% retracement level at the bottom is playing the role of a resistance level before prices broke through and found support at that level in May instead.
Most professional traders who trade with the trend would be buying or getting ready to buy in May at the 38.2% level because the trend is already showing a higher high and higher low. This feature of the Fibonacci retracement can be further amplified by understanding another concept — confluence.
Confluence
I used to draw support and resistance levels to help guide my trades but the results were mixed with several hits and misses. In fact, there were actually more misses than hits, causing me to doubt my ability to identify key levels. Trading off the support and resistance levels did not seem to be enough.
Here is how the Fibonacci retracement came into play. After I was introduced to it, I experimented with the Fibonacci retracement tool and surprisingly found several occasions where the Fibonacci levels coincided with some of my own support and resistance levels. This confluence of levels worked much better. I now had two forms of evidence to show that the supply and resistance levels identified from the overlaps are likely to be key levels. This, in return, boosts my confidence and bolsters my trading psychology.
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Trade management
Using the S&P500 ETF as an example again, I will explain another way I use the Fibonacci retracement (see Chart 2).
Let us say we took a trade on June 1 because prices broke the resistance level in February and rebounded. The prices moved up, and from June 5 to 8, they seemed to be hovering sideways. In such a scenario, traders are usually presented with two paths: Should you take profits or continue to ride the trend? And if you want to ride the trend further, how do you do so?
Here is how you can utilise the Fibonacci retracement. By drawing a Fibonacci retracement from the swing low to the current swing high, you can use the Fibonacci levels as a reference point to shift your trade’s stop-loss.
If this is a strong trend, prices should not retrace by more than 50%. This means you can manage your trade by shifting your stop-losses to slightly below the 50% retracement level. In this example, this would mean shifting your stop-loss to the 50% retracement level at $420.
As we entered the trade at $410 in our example, with the shift of this stop-loss, you are now profitable even if things go south. Otherwise, if the uptrend persists, you can continue to shift your stop-loss and achieve a better risk-to-reward ratio.
Conclusion
In summary, I trust that this article has elucidated how to employ the Fibonacci retracement to discover confluence in key levels, enhance trade management and bolster your trading psychology. It is intriguing to observe how human behaviour can manifest in market patterns through the utilisation of the Fibonacci Golden Ratio. It is imperative to acknowledge that such tools do not offer a guarantee. As traders, we must diligently do our research before initiating a trade. Nevertheless, Fibonacci retracement is still a valuable tool to complement your trading strategies.
Chua Minghan is senior manager, dealing, at Phillip Securities
