Advanced technical analysis
Our favourite fib
Here's how to build a trading strategy around Fibonacci ratios, using our favourite fib.
Our favourite fib is a momentum strategy that works using Fibonacci ratios. We love it because:
- You can use it on various timeframes
- It works across all major markets
- You can use it on bull and bear markets
- It provides a lot of opportunities
You will, however, need to find a market in a clear, strong trend. Ideally, one that's hitting new all-time, multi-year or multi-month highs or lows.
Most traders use this strategy on 1-hour to 4-hour charts, although it can also be effective on daily charts or on timeframes as short as 15 minutes. It is generally more effective on longer-term charts.
However, it's often a good idea to zoom in to a 5-minute chart when planning your entry.
Components of the strategy
This strategy combines everything we've learned about Fibonacci retracement and extension levels. It involves finding a market that's undergone a significant move from A to B, then retraced back to C.
You then look to trade part of the extension of the original move from C up to D, entering a position when the market passes beyond B to new highs or lows.
For this strategy to be effective, though, you need momentum. This means that the retracement to C must be shallow and relatively quick. If the BC line moves beyond 50% of AB, or too much time elapses, then the entry signal is not valid.
Otherwise, you can start to plan our position at point C.
Trading our favourite fib
At C, you can decide your entry, risk management and targets for the trade.
As we've covered, you want to enter your position once the market moves beyond B, then ride the move towards D.
If the market is in an uptrend, you'll want to buy a few points above B. If it is falling, then sell a few points below B. You can choose to do this via a stop entry or market order.
- If you use a stop entry order, then your position will open automatically. However, if the market reverses at this point in a fakeout then you will incur a loss
- Using a market order gives you some time to determine whether the breakout above B is genuine. You could, for example, wait a few minutes before triggering the position – although in heavily trending markets this may lower your profits
At this point, you may want to use a 5-minute or 10-minute chart to pinpoint your entry. That way, you can wait for the price to close beyond B before opening your trade.
This strategy targets two levels:
- The first is at 127.2% of BC. At this point, you can move your stop loss to eliminate risk on the position
- The profit target is the 161.8% extension of BC
In a particularly strong trend, you could set a profit target at 261.8% of BC. To determine the strength of the move, look at the size of the BC retracement. In a strong trend, it should be around 38.2% or lower.
TIP - Watch out for any significant support or resistance levels before your profit target. If your market needs to surpass its 200-day MA before hitting the 161.8% extension, for instance, it might not be the best time to trade.
When you open your position, you'll want to place a stop-loss order at some point on the other side of B. Its precise location will depend on your risk-reward ratio, bearing in mind where your profit target is.
Your risk-reward ratio should be above 1:1 – preferably, 1:2 or higher.
You don't have to wait for the market to return to your stop-loss, either. If you open a position at beyond B but then spot that the market is losing momentum, it might be a better idea to close the trade and cut your losses early.
Here are some examples of this strategy in action.
1. Buying NZD/AUD
Here, the position opens at 0.80240, with the 161.8% level as a profit target at 0.80590. After moving the stop to break even at 0.80383, the position is closed at the profit target.
2. Buying GBP/USD
In this trade, opened ahead of a key economic release, the market moved considerably further than the profit target. The short retracement may have been a clue that 261.8% was a better target.
3. Selling Brent crude
In this example, the breakout beyond B at 10735 quickly reversed into a fakeout. The stop was triggered, limiting losses on the position.