Some traders don’t like breakout formations.
They are uneasy buying new highs and often convince themselves “the move is already over.”
Try as I may to sway them to the contrary, the fear persists. And they usually end up abandoning the trade on the first sign of weakness.
For these individuals, and anyone else who prefers buying pull backs, there are other options. The next price action pattern is a perfect fit for anyone with a low risk tolerance.
What is the Fibonacci Retracement?
It’s called the Fibonacci Retracement. If you’re not familiar with the philosophy, it is based on a series of numbers developed by Italian mathematician Leonardo Fibonacci in the 12th century.
What did a math nerd from the Dark Ages know about trading stocks? Well…nothing to be honest. But his 0.618 Fibonacci Golden Ratio sets up some of the most consistent entry points I’ve ever seen. And traders have been using it with great success for decades.
I don’t know that I subscribe to the full Fibonacci trading method, but what I’m about to show you is my personal favorite from its bag of tricks. Not only is it a precise science for getting into high momentum stocks, but it allows for extremely tight stops. In other words, you only lose a little when you’re wrong.
The idea is this…
Financial instruments tend to move in cycles. When a stock advances or declines by a given percentage, the odds of a reversal increase significantly. The Fibonacci Retracement tool identifies the levels with the highest chance of reversal while establishing precise support and resistance levels.
Let me illustrate this with some currency pairs.
Where To Use The Fibonacci Retracement
This is a daily chart of the EUR/AUD from late 2014.
It was next to impossible to forecast the violent decline. But the pair is clearly in a downtrend. And, like the trading vultures we are, we want a piece of the action. But where do you get in? And how do you know the move lower isn’t exhausted?
This is where the Fibonacci Retracement shines.
You can find the tool in nearly any charting package. And depending on the settings, it will display up to a dozen levels. But we’re only going to focus on two – 50% and 61.8%. These have proven to be the most effective.
Setting Up A Fibonacci Indicator
You want to set the indicator to display from the high to low of the current move. It should look something like this.
I’ve labeled the two key areas we will be targeting, the 50.0% and 61.8% retracement levels. Statistically, a retracement back to these prices will offer the greatest chance of rejection. So to get into this trade (with limited risk mind you) this is the highest probability place to do it.
Here’s how the trade played out.
Notice how the EUR/AUD pair pulled back right into the 50.0% retracement zone and just barely touched the 61.8% level before continuing its move lower.
This was a short trade, but the tool is equally effective to the long side. For simplicity’s sake, let’s stay with the same currency pair.
Fast forward 6 months and the EUR/AUD has turned bullish.
After a quick rally higher, the pair lost steam. It paused twice in the retracement zone before continuing its bullish run.
It did it again the very next month.
The window for entry was small, but Fibonacci Retracement traders with buy limits working scooped some nice gains on the pullback.
One market. 3 trades. 7 months. Not bad for a math nerd from the 12th century huh?
Placing Your Stop
These three examples worked flawlessly. But no matter how good the setup, there will be the occasional loser. Luckily, the Fibonacci Retracement tool provides a nice, tight stop as well. And just like the entry price, it couldn’t be simpler.
You’ll want to place a stop just past the next resistance level, 78.6%. If this area is breached, the pullback is not a pullback – it’s a market reversal. And that means we want out of the trade.
I like to put a stop loss order in a few cents past this level.
That’s it. Wait for the trend to lose steam, enter between the 50% and 61.8% retracement zone, and place a stop on the other side of the 78.6%.
Well there you have it.
Hopefully this article has given you some peace of mind when it comes to trading a breakout formation. It’s not as scary as it looks.
The Fibonacci Retracement is a great tool for jumping on pullbacks and it has an uncanny ability to spot reversals in the market with precise accuracy.
So trade in confidence my friends.
Thanks for reading and I hope this helps!
ps If you liked this article then don’t forget to stay tuned for the final price action pattern that will be coming out later this week!