Fibonacci retracements are one of the best ways to understand market price action. Whether you trade stocks, commodities or FX, markets have a tendency to retrace.
This article shows a way to trade using Fibonacci Retracements. If you want to understand the method that I used to calculate Fibonacci Retracements in Excel you can view the article: Calculate Fibonacci Retracements.
Trading with Fibonacci Levels
I usually want to trade in the direction of the dominant trend. I think this gives the best opportunities to have big profitable trades. One of the challenges of trading with the trend is when to enter a trade. Retracements allow us to enter at what we hope is a good value price. Fibonacci levels are a way to identify these retracement points.
In the chart, the AUD/USD is in a downtrend. This was followed by a period of consolidation. After making a low on 2nd April the price then reacted at the 38.2% level, the 61.8% level and 78.6% level before eventually continuing the downtrend.
Identifying the Trend
One way that I like to use to identify the trend is the Linear Regression line. The linear regression is a statistical tool that creates the best-fit straight line through the price. In this trading strategy, I am only looking at the slope of the line. If the linear regression is pointing upwards (positive value) then I trade long. If the linear regression is pointing downwards (negative value) then I trade short.
Fibonacci Linear Regression Trading Strategy
Putting these two elements together we have a trading strategy that trades long and short based on price action.
I have tested this strategy on the AUD/USD forex pair. I used the daily timeframe between January 2008 and October 2015.
I exited trades using a stop-loss and a profit target. The stop-loss was set to 5 * ATR and the profit target was set to 10 * ATR. A trade could also be closed if another trade opened in the opposite direction. I am using a 50-period linear regression line and a 20 period lookback period for the Fibonacci levels.
Trades were entered on a retracement to the 38.2% level.
Tradinformed Backtest Models
|Gross Winning Trades||$116,516|
|Gross Losing Trades||$-35,939|
|Largest Winning Trade||$15,801|
|Largest Losing Trade||$-7,066|
|Average Profit Per Trade||$2,518|
These tests results show that the AUD/USD performed pretty well over this time period. The strategy relies on a trending market. If we look at the chart on the left it shows that this market has trended well over this time period.
My results showed that the 38.2% Fibonacci level was the most profitable over this time period. This is quite an aggressive entry point. It means that we have a good chance of getting in on the fast-moving trends.
The 50% or 61.8% level would give us a more conservative entry point. However, we would inevitably miss some trends when the market is moving quickly.
Check out further explanation of the strategy by watching the video on YouTube.
How to Develop a Trading Strategy
If you are interested in developing trading strategies my eBook is available in the Amazon Kindle Store. It is called: How to Develop a Trading Strategy. The book contains lots of advice and suggestions including coming up with ideas, refining the strategy and then making it profitable.