Our Favorite Fib
Our Favorite Fib is a Fibonacci-based strategy that takes advantage of momentum. It can be used on various time frames and markets, including FX majors, stock indices and commodities, providing the trader with endless opportunities. The strategy could be used, for example, after some major economic news – ideally, at the earlier stages of the move following the news. But if the news merely causes a corrective rally or sell-off inside an established trend, then this strategy won’t work as well. Thus it is suited for markets that are in a clear strong trend e.g. when price is making fresh all-time or multi-year/month highs or lows.
The higher the time frame, the more effective the F/F strategy works. It is typically used on 1 or 4 hour time frames, although sometimes it could be applied to the daily time frame, too. The shortest time frame that one can use this is strategy on is about 15 minutes. However if the trade is based on a higher time frame, then it is a good idea to zoom in to a 5-minute chart in order to refine entry.
Components of the strategy
The F/F strategy is based on some Fibonacci retracement and extension levels. These are the 38.2% and 50% retracement levels (the latter, in fact, is not a Fibonacci level), and the 127.2%, 161.8% and 261.8% Fibonacci extension levels.
To understand how the strategy works, let’s say that following a strong upward move (e.g. from point A to B), the market retraces a little (to point C) because of profit taking and/or top picking, before continuing in the original direction (beyond point B). This strategy requires 3 price swings – the move from point A to B, B to C (correction), and C to D (extension). Here is how an F/F buy strategy would typically look like:
In the F/F strategy, we are interested in some part of the CD leg of the move – the bit beyond point B, where entry is based. The profit target would be determined by a Fibonacci extension level of the BC move (more on this below).
One condition for this strategy to work well is that we need momentum. By definition, this implies point C should represent a shallow retracement of AB, and then a continuation in the original direction, beyond point B. Therefore, if price retraces more than 50%, or too much time elapses, before it breaks point B, then the entry signal would not be valid.
In other words, for optimal entry signal, we need a strong move from point A to point B; a relatively quick and shallow retracement of less than 50% to point C, and then a continuation towards point D.
Once point C is established, all of the strategy’s parameters can be determined. Before discussing the entry and closing levels in detail, here are a few examples of how the strategy would work:
Example 1: Buy NZD/USD
After: Target reached
Example 2: Buy GBP/USD ahead of a key economic release
After: Target reached
(note that the 261.8% extension could have been a better target, in this case)
Example 3: Sell Brent crude oil
After: stopped out
(due to false breakout and/or premature entry)
Example 4: Buy gold
(rally lost momentum; 50% level was breached)
The entry would be based on break of point B and the objective is to ride the move towards point D – which would be a Fibonacci level, determined by the BC swing.
For a buy (sell) trade, the entry could be via a stop buy (sell) order a few pips/points above (below) point B, or alternatively it could be via a market/limit buy order once point B is broken.
- Entry via a stop order ensures the trade would be triggered. However in the case of a false breakout, it could mean buying (selling) right at the high (low). What’s more, if the market gaps, the entry may not be at the same level as the one the trader had chosen.
- Entry via a market or limit order allows the trader some time to determine whether or not the breakout above (below) point B is genuine or false. If price holds above (below) point B for say a few minutes, then the trader may wish to buy (sell) at the best available price. However the risk is that the market moves quickly towards the target without a pullback, and the trader misses the opportunity.
If the entry is based on a higher time frame like the 4 hour chart, the trader may wish to hold fire and zoom into a 5 or 10 minute chart and wait until price closes above (below) point B on the lower time frame before buying (selling).
The F/F strategy has two targets
- The first target is the 127.2% level of BC, at which point the stop loss would be adjusted to breakeven to eliminate risk.
- The second (i.e. profit) target would be the 161.8% extension level of BC (or sometimes the 261.8%), at which point the position should be closed.
One way to estimate which level price would most likely extend to, is by looking at the retracement of the AB swing i.e. point C. If the retracement is around 38.2% or lower then point D could be at the 161.8% or sometimes 261.8% extension of BC. However if price achieves a deeper retracement, say to the 61.8% or 78.6% Fibonacci level of AB, then one should expect point D to complete around the 127.2% extension of BC. Of course this would not be a valid Favourite Fibo entry, since the retracement was greater than 50%.
For a buy (sell) trade, the stop loss would be some distance below (above) point B, ideally below (above) a small fractal within the larger swing. The maximum distance between the stop loss and entry should be less than the distance between entry and the profit target. In other words, the risk to reward ratio should be better than 1:1 (ideally 1:2 or superior).
- For a higher probability trade, the entry should be in the direction of the underlying long or medium term trend
- The speculator should be aware of other, longer-term, technical levels when trading the Favourite Fibo strategy. For example, if the 200-day moving average is at 1.8560 and the target for the long position is at 1.8580, this trade should not have been taken. In this situation, it may be better to take profit at around the 200-day average rather than hope for price to reach the 161.8% extension i.e. the original profit target that was based on a smaller time frame. The minute you notice yourself hoping for something to happen is when you know the trade is in trouble – get out ASAP.
- The trader should avoid taking on opposing simultaneous trades in similar markets e.g. going long on DAX and short on FTSE, or long on NZD/USD and short on AUD/USD etc. If the trader is feeling bearish about the AUD and at the same time bullish about NZD, he/she should look for a short trade on the AUD/NZD pair instead.
- If price breaks point B, therefore triggers the entry order, and then loses momentum prior to reaching the first target (127.2%), the trader should close the trade at the best available price (even if it is worse than the entry price – why wait until being stopped out?). After all, the whole objective of the entry was based on expectation of a generous continuation move, which hasn’t happened. You can’t force the market to give you what you desire; hence you should never blame the market for getting it wrong, but your own ability or lack thereof to respond to changing dynamics or conditions of the market.