In the previous 13 articles on Fibonacci many various topics have been discussed such as the why Fibs work, Fibonacci retracements, roles, trigger, entries, targets, Fibonacci sequences, Fib confluence, invalidation levels and stop losses but also how to place Fibs using an oscillator, candles, swings.
Today our mission is to discuss the “mental game” when Fib trading.
Price can respect any combination of Fibonacci levels but the trader never knows which one.
Let me explain with 2 examples:
a) A currency can bounce at 38.2% but eventually retrace deeper to 61.8% before moving to target.
b) Or it could bounce at the 23.6% Fib, break through the 38.2% and bounce at the 50% Fib before going to target.
It is the trader’s job to make an estimate about each Fibonacci level and judge which one has the best probability of moving to target. How are traders able to complete this analysis?
Traders need to use chart confluence to judge which Fib level has a high chance of being used or respected by the market. When there is more confluence, then there’s a higher probability of price bouncing at the Fib level.
From my own trading experience, I use a rule of thumb that says 2 out of 3 Fib levels will be respected and 1 out of 3 will not be used on 1 time frame. Ultimately even if a Fib level has not received a reaction from the market on i.e. daily chart, it could have been respected on a lower time frame like a 1 hour. The main point is that not all Fib levels will be respected. Some Fibs will break (+/-33%) but most will hold (+/-67%) when using a proper swing.
I have read a study that showed that deeper Fibs are used more often than shallower ones (do not have the source anymore). It explained that:
a) About +/-25% of the time price reverts back into the trend from either the 23.6% or 38.2%;
b) About +/-20% of the time price reverts back into the trend from 50%;
c) About +/-20 % of the time price reverts back into the trend from 61.8%;
c) About +/-35 % of the time price reverts back into the trend from 78.6% (or 88.6%) Fib.
There are 3 main groups: shallow Fibs like the 23.6% and 38.2%, medium deep Fibs like the 50% and 61.8% and deep Fibs like the 78.6% and 88.6%.
Are used in strong trends and momentum and have their own pros (advantages) and cons (disadvantages):
Pro: a trade can often develop quickly to target.
Con: price is very far from the bottom or top which makes a stop loss (SL) placement either risky of getting hit (tight SL) or large in size (wide SL).
Con: there is a decent chance for price to retrace to deeper Fib levels (see previous paragraph).
Battle plan: I am very cautious when trading shallow Fibs because there is a 75% chance of price going deeper so most of the time I will not trade directly at the shallow Fibs. Instead I rather wait for price to bounce at the Fib level and take a breakout trade.
Are the most used Fib levels (40% in total) and have their own pros and cons:
Pro: good reward to risk balance because stop loss is not very far away like with shallow Fibs.
Pro: these Fibs levels are psychologically strong because one is the half way mark (50%) and the other is the golden ratio (61.8%).
Pro: shallower Fibs have already been broken and only a few lower Fibs are left. There is a decent chance that price will in fact bounce in this zone.
Con: sometimes price move back to the medium Fib levels with lots of momentum. Taking a trade against the momentum feels like catching falling knife.
Battle plan: I like the medium Fibs and am willing to use pending orders in some cases when I see heavy chart confluence and judge the probability of a bounce to be high. Other times I wait for price action to confirm a bounce at the medium Fibs – especially when momentum is developing to the other direction. The medium Fibs offer good R:R, decent probabilities and relatively quick trades.
Offer the best reward to risk and have their own pros and cons:
Pro: excellent reward-to-risk (R:R) balance because the stop loss invalidation level is nearby.
Con: price retraced a big part of the previous price movement and there is a higher chance of a triangle chart pattern occurring (or in other words indecision).
Con: when price goes that deep it could also indicate a reversal. It’s a smart idea to double check whether the used Fib is properly placed.
Battle plan: deep Fibs are interesting because they can become the start of a new trend and offer superior R:R’s. Then again, price can also get stuck in a triangle so holding times of a trade are longer too. Be ready for this when trading deep Fibs or decrease R:R to decrease the length of the trade.
Check our ecs.SWAT course and trading system for more information how to use Fibonacci.
Before leaving, make sure to read our entire Fibonacci series!
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