Most fx traders are familiar with the concept of Fibonacci trading. The basic premise is simple. Price does not move in 500 pip straight-line movements. Instead, when price does move in a directional flow, it may move 40 pips, then pull back 15, then move another 30, and pull back 10, etc. When price pauses and retraces for a small corrective move, Fibonacci can be applied to charts in order to determine where that entrancement move may exhaust.
Here is a simple example of price exhausting at a Fibonacci level:
As you can see in the chart above, price found support at the 50% Fibonacci retracement of the overall Swing Hi and Swing Lo. Most traders who utilize Fibonacci analysis in their trading use Fibs in a manner similar to this example. They draw Fibs on Swing Hi’s and Swing Lo’s and then aim to predict potential exhaustion points during price retracements.
There is, however, an alternative method of Fibonacci analysis that is very effective— the Backside Fibonacci Bounces.
Now, what happens when price violates a Fib level and moves beyond it? Well, most traders simply give up and don’t look any further at that particular Fib level. This is a major mistake, and the reason involves order flow.
Order Flow and Fibonacci
This article is about Fibonacci, and not about order flow. Order flow is a very complex subject matter, but in order to properly understand why backside Fib levels work, it is imperative that one have, at least, a very elementary understanding of order flow.
Fibs work primarily due to self-fulfilling prophecy. While there may not be a mathematical mystery to the universe, such as the Fibonacci number sequence, that controls financial markets, there most definitely are tens of thousands of traders around the world who monitor Fib levels and place trades around those levels. Therefore, price tends to react around Fib levels.
Now, when price falls to a Fib level during a retracement, but does not find any support and moves straight through, this broken Fib level ought to be treated as a broken support/resistance level or broken trendline, and one ought to then look to fade the retest of the broken Fib level, in expectation that the sellers who have now offered that level will protect their orders by selling at the retest of the broken Fib level.
In the chart above, look at all of the backside Fib bounces that played out. You can see 6 red-shaded circles that each show a clear backside Fibonacci bounce.
The Best Market Conditions
Every strategy or trading methodology tends to have specific market conditions when it will outperform and also when it will underperform. Playing backside Fibonacci bounces will work absolutely best when the entry is in the direction of the Daily trend.
For example, let’s assume that EUR/USD is in a clear bullish trend on the Daily Chart. Then, for a two-day period it begins to retrace to the downside in a bearish corrective move. The price action may look something like this:
Now, when price begins to make its move back to the upside in the direction of the bullish daily trend, draw a Fib on the last corrective wave and look to play any backside Fib bounces.
In the example above, you can see a clear setup on the backside of the 38% Fib. These levels setup constantly, but the very best method to play them is as described here when the entry is in the direction of the macro trend. This will add probability to trade.
Guest post by Sara Mackey of ForexFraud.com