Another way to identify more significant levels of support and resistance in terms of trend reversals is based off previously established significant highs (peaks) and lows (valleys). These peaks and valleys help a trader identify the beginning and ending points of price swings, or trends.
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Based off these significant highs and lows, a widely recognized form of technical analysis referred to as Fibonacci retracements may be used to identify support or resistance. These Fibonacci retracement levels represent percentage corrections of previously established price swings, or trends. The most common Fibonacci retracement levels are 38.2%, 50%, 61.8%, and 78.6% of the previous swing, or trend.
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In the above example, we see the completed doji (point C) has also occurred at the 78.6% Fibonacci retracement level of resistance based on the previous downtrend. In other words, the swing from the low up to the completed doji (B to C) is approximately 78.6% of the previous downtrend (A to B). In this case, a trader may interpret this doji as confirmation of the Fibonacci resistance, and in turn, anticipate a forthcoming reversal, or downswing. If the doji fails (a new high is made above the high of the doji), then this would negate the reversal and suggest a potential continuation.
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Based on this basic idea, a trader may then decide to enter the market short (place a sell order) with a stop (or sometimes referred to as a stop loss) placed above the high of the doji and the Fibonacci level of resistance. Since this stop-loss order is meant to close out a sell entry order, a stop buy order must be placed.
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What is very important to remember is that the highs, lows, opens, and closes seen on a price chart reflect the bid prices of that particular market-in other words, the price at which a trader may sell. When placing a buy order, it is extremely important to account for the spread in that particular market because the buy (ask) price is always slightly higher than the sell (bid) price. In this example, let's assume the spread on the USD/CHF at the time of this trade is four pips.
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In order to close the short/sell entry order the trader must place a buy order to either control the amount the trader is willing to lose with a stop loss or where to take profit with a limit order (or multiple limit orders if multiple profit targets are established). The size of each stop or limit order is based on the size of the entry order, or what is referred to as the trader's open position. Although it is not uncommon for traders to have multiple profit targets, it is generally good practice to have one stop order that matches the size of the total open position, thus taking the trader completely out of that position.
| More on Monday in Part 3. | Read Part 1 |
By Roger A. Stojsic of GFTForex.com
