But they are hard to get right. Hence, we should focus on limiting risk when we get things wrong. This tutorial will use a retracement zone to contain our risk in a reversal trading strategy. Reversal Trading Step-by-Step For clarity, we will break down the strategy into three steps with explanatory charts. Identify a significant trend Project and adjust retracement zones Step 1: Identify a significant trend To target high potential rewards, we should focus on reversals of significant trends.
If we catch a major market reversal, we would be in a great position to profit from the emerging trend. A prime indicator of the dominant trend is the period simple moving average SMA. To identify a noteworthy trend, we look for gaps between price action and the period SMA. The litmus test here is if you are not sure, it is not a trend.
The chart below shows a bullish market with most of its price action above the SMA. Step 2: Identify potential reversals After identifying a trend, we look out for clues of a potential reversal. In a bull trend, if the market pushes down enough to test the SMA, we go on high alert. This is the situation highlighted in Point 3 in the chart above.
In a bear trend, if the market rises sufficiently to test the SMA, we go on high alert. What does high alert mean? Step 3: Project and adjust the retracement zone The bull trend testing the SMA is a definite attempt to reverse the trend. What are retracement zones? Look at any price chart.
After a price thrust, the market retraces part of the thrust before pushing further. This pattern repeats itself and results in the wave-like market structure that we see. Projecting reliable retracement zones depends on identifying a meaningful anchor thrust e. The higher the percentage, the more likely that the market is in a range.
The lower the ratio, the more likely that a strong trend is in place. There is nothing magical about these precise levels. And we include a standard Fibonacci level The first step to projecting a retracement zone is to identify the anchor thrust.
Here, we will use the push from the trend extreme to the SMA as our anchor thrust. Not sure what we mean? It enlarges the right half of the earlier chart. Why are we using this down-thrust as our anchor thrust? If the expected bear trend materializes, this down-thrust will be the first thrust of this new bear trend. Hence, it offers a significant swing for projecting retracement zones.
Another important note is that we must adjust the projection as the thrust extends. The adjustment will follow each bar that pushes to a new low. While the start of the anchor thrust is fixed, its endpoint shifts as the market pushes down. The chart below shows the final adjusted zone before the market rose to test its efficacy as a resistance. In some cases, adjusting the zone could push the zone below the SMA. If that happens, we skip the setup. Likely, the reversal has already taken off, and we have missed the boat.
Trend retracement setups would be more appropriate then. Retracement is a crucial idea in Elliot Wave theory and Fibonacci trading concepts. While they are not our focus here, you can look them up to dive deeper into using retracements. You might be staring at the chart above and thinking, how about the earlier test of the SMA? Why are we not talking about that?
Reversal Trading Examples With any trading method, however well-defined, each trade will play out differently. Hence, reviewing examples is one of the best ways to understand a strategy thoroughly. Trading Example 1: Bear Trend Reversing Into A Bullish Market This chart shows a textbook example of this method, and you must recognize that many trades might not be as ideal.
But it does illustrate the incredible reward-to-risk ratio when you get it right. This is the extreme low of the bear trend before the market rose to test the SMA. This test of the SMA established the anchor thrust for our projecting the retracement zone. Not only that, this excellent two-bar reversal pattern helped with controlling our risk. Stop-loss below the pattern.
The sequence continues to infinity. How to plot it on your chart On your chart, you will see the indicator as different lines for different levels. The set-up of this indicator is a straightforward process since it is a built-in tool in most trading platforms. When plotting it, you should draw a line from the lowest price to the highest price or vice versa, if it is a downward trend and the levels will be placed automatically.
Before plotting the Fibonacci lines on your chart, set a trend line connecting two extreme price points, such as the lowest and the highest prices for the period. Afterward, each Fibonacci level is presented as a horizontal line, which intersects with the trend line.
The Fibonacci levels for each line are expressed as a percentage for the retracement and they are: 0. The ratio of The Other Fibonacci retracement levels are calculated based on ratios or rules that follow the Fibonacci sequence.
The aim of using these levels is to examine how much the price has retracted or corrected compared to the previous movement. You will use the Fibonacci retracement lines to identify potential points at which prices will bounce back and reverse towards the previous movement. You can set up your Fibonacci retracement indicator on a chart for different assets and financial instruments and for different time frames.
It should be noted, though, that longer time frames can provide a better overview of the price movement toward retracement levels compared to short time frames. Understanding Fibonacci levels depth You can plot different Fibonacci levels on your asset chart. Since the levels represent the size of the retracement from the prior movement, there is a difference from one level to another in terms of their depth.
Fibonacci retracement trading strategy The indicator is used by traders as part of a trading strategy because it can help predict potential entry and exit points and whether you should go long in the market, or should sell — or short sell, for that matter. As a trader, you can expect that prices will probably reverse toward the trend direction once they reach certain Fibonacci retracement levels.
Fibonacci trading is recommended in a trending market. Hence, you should primarily try to identify a strong market trend, or be on a lookout for an asset in a strong trend. In periods of trending market conditions, prices exhibit a certain level of a pullback before they reverse. You can set up the Fibonacci indicator levels to determine signals for a potential reversal and open a position in the same direction as the primary trend.
Executing trades using a Fibonacci trading strategy would mean you look for entry points at the retracement and wait for the price to move back in the direction of the initial trend. Fibonacci retracement can also be used to identify signals for a potential reversal in prices. Fibonacci support and resistance levels Fibonacci support and resistance levels are the levels at which you can expect a reversal, and the levels can signal entry points. When using the levels as a support or resistance, the idea is that you will take long positions when retracements reach a Fibonacci support level during an upward moving trend.
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