When it comes to CFD and forex trading, what all traders could benefit from is an eye into the future, however since that’s impossible, the next best thing is certain strategies that can help you make sense of past performance, namely patterns, in order to speculate what an instrument might do next. That’s where one particular strategy called Fibonacci Retracements may come in handy. Using special ratios developed in India in 600 AD, traders have worked out a method to potentially get a glimpse of market behaviour before it happens. This might seem impossible, and, indeed, this method will not work every time it is used, but analysis of many price charts seems to indicate it has validity, and it is widely used in forex trading today to gain a sense of insight.
We see that certain ratios exist in nature, for example the golden ratio that governs the expansion of a spiral, which we find in galaxies and shells. Human behaviour is also a part of nature, so why shouldn’t we find those same ratios describing patterns in our conduct over time? When you look at a price chart, you are really looking at a pattern in the behaviour of many people over time: the fluctuations in their hopefulness, euphoria, and fear through the stages of buying and selling. The theory is that the same patterns that occur in shell formation are thought to occur in the stages of traders’ relationships with their instruments. Let’s look deeper into this fascinating approach to forex trading and draw down some practical examples.
Before we get into details, let’s follow through with the theory. If many people take part in a buying trend, which keeps pushing up an instrument’s price, which, in turn, attracts more buyers, there will be a certain point at which their optimism will dull. They will start to question whether these changes are happening too quickly and how long they can be sustained. They will hesitate. Then, they will either decide the enthusiasm is warranted and continue the buying spree or change their minds and decide it’s time to sell. Fibonacci levels aim to identify these points of hesitation.
Their method of doing so is this: Choose a point on a chart where prices hit a peak before dropping to a much lower point. Draw two horizontals: one at the peak, and another at the trough. This establishes a period of time during which you will be analyzing the trading behaviour that took place. Let’s say this dip represents a price drop of $10 in the given instrument. After the trough, though, prices start to creep up again and have reached the level of the 38.2% mark between the high and the low, which is a Fibonacci level. If our theory applies, the pullback in negative sentiment is likely to pause at this hesitation level, before either pushing up further or dropping back down. Now we wait a few days and see if we were right: the price lingers on the 38.2% level for some time. Following this, prices take off again and your trendline goes up. Now it seems the hesitation was really a more permanent change in sentiment for the positive, rather than an afterthought in an enduring trend of negative sentiment. Based on this analysis, you may choose to open a “buy” deal for this instrument, because our analysis indicates we’ve found the beginning of an uptrend.
Naturally you’ll ask where we got this particular percentage from. The answer is: from the same ratios underlying shell structures, which are 23.6%, 38.2%, 61.8% and 78.6%. These are the Fibonacci levels.
Fibonacci and Stop-Loss
Aside from using Fibonacci levels to determine when to open a deal, traders use them to know where to put their stop-loss orders. For instance, a stock price rises steadily for some weeks and then sinks back to the 78.6% level, where it lingers. Then, it starts to rise again. As per the explanation above, you may choose to open a “buy” deal at this point, but you also may set your stop-loss order at the 78.6% mark. The reason is that, in the event prices fail to take off this time and dip, it would seem our expected rally didn’t happen, so an informed trader may be convinced to open a ‘sell’ deal before prices drop further.
Traders usually do not take their sole guidance from Fibonacci Retracements but use them in conjunction with other indicators. Take note they are not perfectly accurate, but rather give a general indication of where a stalling point might form. Even if you employ them faithfully, you’ll never be 100% sure prices will stop at a given level, because another level might be applicable in this case. Still, with experience, this can become a useful part of your trading strategy because it helps you form an even stronger grasp on the behaviour of your chosen CFD or forex trading instrument.
It’s advisable to read up as much as you can on Fibonacci Retracements and get some practice using them, as they could enhance your effectiveness as a CFD or forex trader. Always remember to take a broad look at the picture, though, and consult a good amount of market analysis before acting.
Categories: Stock Market