Great Examples of Fibonacci Analysis–Part 3
01/20/2009 10:26 am EST
We've now discussed finding entry points, setting stops, and projecting initial profit targets in the previous lesson. I’ve found that it’s usually harder to decide what to do with the trade once you have entered it. Especially when the trade moves as you expected it would. Is it appropriate and possible to adjust stops and project price targets once initial projections have been met?
I find Fibonacci retracements invaluable when trying to answer these questions. In this section, we will talk about adjusting stops and projecting price targets beyond initial estimates.
Risk control is critical for survival in the forex. One of the most popular methods for risk control (on a trade-by-trade basis) is the stop loss. In the last section, we talked about how to set an initial stop. But once the market begins to move, it may make sense to adjust those stops. In this example, we will repeat the steps from the previous lesson, but will look at a specific scenario for moving your stop.
1. The Fibonacci retracement was drawn from the top to the bottom of the trend from early to mid-November (1). Because the trend was down, you would have been looking for short opportunities.
2. Following the bottom in November, prices rebounded to the 38.2% retracement level at 229.00, and then bounced down to continue the trend. The move up to the retracement level is what creates the opportunity to short the market as the trend continues to the downside.
An opportunity for a trade could have been found with a limit order (automatic order at a certain price) to short this pair midway between the 38.2% retracement level and the 23.6% retracement level (2) at 227.50. This would be placed in anticipation of the potential bounce down off resistance at the 38.2 level. In the last lesson, we discussed using the midpoint between two Fibonacci levels as a good entry point following a support or resistance bounce.
3. At the same time that a limit order to short the pair was filled, a stop order for risk control should also be entered. In the last section, we discussed placing the stop on the other side of the Fibonacci level that prices bounced off about a third of the way towards the next Fibonacci level. In this example, prices bounced off the 38.2% retracement level at 229.00, and the next Fibonacci level is the 50%, at 231.50. Therefore, the stop would be placed at 229.83 (3).
In steps 1-3, we talked about the initial trade setup. So far we have used the information from the last section to establish a short position on the GBP/JPY based on the Fibonacci levels. In the next few steps, we will talk about how this trade worked out and how we adjusted the stops.
4. Following the entry at 227.50, prices almost immediately fell to the next Fibonacci level of 23.6%. This was in line with the original forecast. But don’t get antsy and adjust your stop yet. We recommend you wait until the next Fibonacci level has been reached. In this case, the 0% level was not reached before the trade was stopped out on Dec 12th.
This is a good example of how even the best analysis, predicted correctly, will sometimes not always work out. But the good news is there’s another good setup around the bend.
5. The stop in December was bittersweet, since prices immediately moved back below the 38.2% retracement level, proving the analysis is correct. That move would have triggered another trade because prices are again bouncing off the 38.2% retracement level, with an identical setup to the trade constructed in steps 1-3.
6. Prices followed the trend and hit the 0% line on 12/31, which was a trigger to reevaluate the stop loss. A good rule of thumb here is to move the stop down a full level to rest just above the 23.6% retracement level. This pattern can continue to be repeated as prices exceed lower benchmarks, however, it is important to leave plenty of room between current prices and the stop loss, or you may find yourself right on direction but wrong on the whipsaw. Always remember: Tightening your stops reduces your downside exposure, but increases the chances for a whipsaw.
Adjusting the Profit Target
Once the initial profit target, or the bottom of the formation has been exceeded, you can use Fibonacci retracements to project a new profit target. In this situation, move the Fibonacci analysis so that it encompasses the price action from the bottom of the original study to the top of the bounce (late Nov. to early Dec.) that triggered the original trade above. See the chart below for an illustration.
This would have projected new Fib levels above or below the original price range. The key level is the 161.8% retracement as the next likely target, but even further beyond that is the 261.8% retracement level. As prices reach either of these levels, you could reevaluate your stops again and even consider an exit to take some profits off the table.
This simple analysis is surprisingly predictive and provides a basis to evaluate new targets. Let’s take it further now.
1. A new retracement has been drawn from the bottom of the November decline to the top of the rally at the beginning of December.
2. A new profit target can be seen at the 161.8% retracement level at 216.00. You can see that prices did consolidate at that level for about a week in January. This is a great time to consider moving your stop to just above the bottom of the retracement.
3. At that point, you could have decided that if prices breakthrough the 161.8% retracement level and there are no other reasons to exit the trade, you may consider moving your profit target to the 261.8% retracement level.
As you can see, this turned out to be quite predictive as the bottom of the market.
Beware of the X-Factors
Stops and/or Diversification
Using stops for risk control is advisable, but they can lead to some volatility when the market whips you out of a position on your stop, as it did in our example today.
Using stops is great, but it leaves your risk control strategy incomplete in that it’s the only thing you are using to reduce account volatility. Diversification is another compelling way to reduce systemic risk and improve returns. Used together, these two tools can help smooth your equity curve and make your trading less stressful.
Generally, I try to establish ten or more uncorrelated positions and/or strategies at the same time. This allows me to benefit from diversification without increasing my management responsibilities too much. This is a great argument for longer-term investing. It is easier to manage ten or more positions when the trades last longer than a short-term or daytrading basis.
Adjustments and New Information
In general, I am opposed to sticking to a trade’s original analysis in the face of new and better information. Reducing your risk means that you are willing to reevaluate what you are doing with tighter or looser stops based on the information you have today. This is a concept I mentioned in the last section, and I think it is one of the most important things traders can learn to become successful.
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