TRADERS´STRATEGIES

An Objective Leading Indicator

Fibonacci Retracements

This article explains how to use Fibonacci as a leading indicator, combining

it with other technical analysis tools to provide precise, objective entry
points for a trading strategy. A leading indicator means that you can
decide on likely direction ahead of it happening as compared to a lagging
indicator which only predicts movements after it has already started to
occur. As Fibonacci is a leading indicator you will see the entry point and
place an order in advance of the market reaching your desired level.

F1) Fibonacci Retracement Ratios o This strategy can be applied to all liquid, technical
markets and can be applied across time frames from one
minute up to one month.

Fibonacci – Leading Not Lagging

Some may argue that Fibonacci is a subjective indicator or
one that only works in hindsight but then again smart people
the world over always have and always will continue to hold
contrary views. The important thing in trading is that you
find what works for you and stick to it. Fibonacci is a great
leading indicator once you know how to use it correctly.

The article will explain:

• Fibonacci as a part of your current trading strategy or any
strategy involving pullbacks/retracements.
• A precise trade entry point where Fibonacci levels
Retracement levels used by Precision Traders are 38.2%, 50%, 61.8% and 78.6% only. cluster.
Source: www.tradestation.com
• Correct stop-loss levels.

48 February 2010 | www.traders-mag.com


• Fibonacci extensions for target setting.
• Other technical indicators to use in conjunction with
Fibonacci.
Is Fibonacci Scientific?
Fibonacci has some scientific foundations and its study
is used across far more subjects than financial markets.
Fibonacci has links in the human body, animals, breeding
patterns, nature and religion.
If you want a history lesson on Fibonacci, all it takes is
a quick Google or Amazon search and you will be spoilt for
choice. While it may be interesting, history lessons rarely
help you make money. This article focuses on using Fib as
part of a technical trading strategy, in fact, any technical
trading strategy that involves trading pullbacks of a trending
market. The goal, as with any good strategy, is to give you
extra edge in the markets and ultimately make you a more
profitable and consistent trader.
Is Fibonacci Self-Fulfilling?
In short, no. For a technical indicator to become self-fulfilling
it implies that not only are many traders using it, but that they
are all using it the same way and actually applying the analysis
correctly. Fibonacci is based on a combination of trends,
mathematics, trading skill, experience, intuition and lots and
lots of practice. Because someone draws a Fibonacci line
on a chart does not mean they have any of these required
ingredients. Having a strategy is just one thing, applying it
correctly and consistently means you ‘own it’ rather than
simply ‘understand it’. This can only come through years of
practice, highs and lows.
What Is a Fibonacci Retracement?
After a move up or down in the market, at some point
the market will start to ‘pull back’ or ‘retrace’ – this has to
happen. No market can go in one direction for ever. As
the market starts to retrace, a good trader will draw a
TRADERS´STRATEGIES
F2) Price Action Uptrend
Higher highs (HH) and higher lows (HL); understanding when a market is trending and the precise moment that
the trend reverses is the most important thing a trader can ever do. It‘s also very simple, most new traders just
don’t put enough emphasis on it.
Source: www.tradestation.com
Fibonacci line from the start to the end of the move to see
the probable points of retracement. This results in multiple
lines drawn horizontally across the chart that the price may
be supported or resisted at if price reaches them (see Figure
1). Common retracement levels are 23.6, 38.2, 50, 61.8, 78.6
and 100 percent. This means that after a move in either
direction (which equals 100 percent), the retracements could
be 38.2 or 50 percent or so on, back in the opposite direction
of the 100 percent move. If the full move reversed, then
this is considered a 100 percent retracement. The problem
is that as the price retraces, there are many retracement
levels to choose from. Which level is the market most likely
to turn at? More importantly, where is a good place for
you to enter a trade? At this stage we don’t have enough
information to answer that question; there is no high
probability trade with just this amount of analysis. This has
February 2010 | www.traders-mag.com 49
 TRADERS´STRATEGIES
F3) Price Action Downtrend
Lower lows (LL) and lower highs (LH); same as Figure 2.
Source: www.tradestation.com
led some people to say that Fib is subjective. Well, the truth
is, it is subjective…but only for those people who don’t have
a precise strategy for how to use it. If you cannot pinpoint
a trade with precision, i.e. the exact retracement level that
you would like to buy or sell at, then you do not have a
trading strategy. All you have is a very subjective and borderline
useless trading tool. So, let’s cover how you can pinpoint the
precise Fib retracement level that has the highest probability
of the market turning. To understand the full trading
strategy you must first understand trends at the basic level.
Trends – A Series of Highs and Lows
Trend analysis is the most straightforward, most important
and yet most overlooked technical tool at our disposal. Many
traders skip over it because they think higher highs and higher
lows is ‘too simple’. They think the advanced stuff (such as
F4) Correct Drawing of Fib Lines
Correct drawing of Fib lines within a downtrend, starting from the most recent high and drawing to the most
recent low.
Source: www.tradestation.com
50 February 2010 | www.traders-mag.com
Fibonacci) is what will make them more money and open up
the secrets to wealth and success through trading. This is not
true, not even close to it! Without a grasp of basic technicals,
the advanced stuff never quite makes sense. Correct trend
analysis is the most important thing that a trader can ever
understand. It is also essential for drawing Fib lines correctly
– there is no retracement without first having a trend.
An uptrend is:
• A series of higher highs (HH) and higher lows (HL) (Figure 2).
An uptrend is over when this trend reverses, i.e. the price
makes either a:
• Lower high (Figure 2 point A) and/or,
• Lower low (Figure 2 point B).
A downtrend is:
• A series of lower lows (LL) and lower highs (LH). See
Figure 3.
A downtrend is over when this trend reverses, i.e. the price
makes either a:
• Higher high (Figure 3 point A) and/or,
• Higher low (Figure 3 point B).
Fibonacci Is for Trending Markets Only
Important rule – only draw Fib retracements when there
is a prevailing trend. All trends have to retrace in order for
the above definit ions to be true, i.e. in an uptrend price has
to pull back from an HH to make an HL. Trading with the
trend is also the highest probability trading – looking for a
retracement of the current trend ensures you have momentum
behind the move. If there is no clear trend then by using Fib
retracements you are swimming upstream before you even
begin. Fib does not work in ranging markets! The nature of
a ranging market is that it will range between two levels,
hence pulling back approximately 100 percent of each prior
move – retracements in this situation are useless.
Now that you are trading with the trend, you can draw
your Fib line in the direction of that trend. A start point for
this line should be an HL within an uptrend or an LH within
a downtrend. Refer back to Figure 2. Each HL was a possible
start point for your Fib line. You should draw it upwards
in the direction of the trend. Equally, in Figure 3, each LH
was a place to start a line from and draw downwards in the
direction of the trend.
The most important place to start from is:
• The most recent low within an uptrend.
• The most recent high within a downtrend.
Remember the above points as they are the most crucial
steps in applying Fib correctly. This will ensure that you
are only looking for retracements of the current trend in
the time frame you are trading. Caution – do not look for
retracements of a trend that has just reversed. For example,
look at Figure 3. We have now reversed the downtrend
and are uptrending (made an HH & HL) so there is no point
drawing a Fib line downwards any longer. In fact, if you were
to draw a line on this chart right now, the only place to do it
would be with the uptrend from the last LL up to point A.
Completing the Fib Line
 TRADERS´STRATEGIES

There are highs and lows all over the chart, so which one do F5) Fibonacci Cluster within an Uptrend
you use? The answer is very simple: The line should always
end at the extreme, i.e.:
• The most recent HH within an uptrend or,
• The most recent LL within a downtrend.

We clarified earlier that in the absence of a trend, there is no

Fib retracement to be drawn. Also, once a new high or low has
been made (a new extreme), new Fib lines need to be redrawn,
your old ones are now invalidated as you would no longer be
looking at a retracement of the current trend.
Look at Figure 4 for an example. You MUST draw your Fib line
as shown from point D (the most recent high) down to point E
(the most recent low or the extreme). There is no point drawing
a line from C down to X2 any longer. X2 was a valid low when it
was the extreme, however now a new low has been made at E
and this is the ONLY point where Fib lines should end.

To Confirm: The figure shows a cluster of the short-term 50 percent and longer-term 38.2 percent.
Short-term move Source: www.tradestation.com

• Within an UP trend, you MUST always draw your Fib line

starting from the most recent low and finishing at the
most recent high. clusters for an entry point, the 38.2 percent will only be used
• Within a DOWN trend, you MUST always draw your Fib for the long-term move, e.g. a 38.2 percent move for the
line starting from the most recent high and finishing at longer term may cluster with the shorter-term 50 percent
the most recent low. or 61.8 percent level.
• Both of the above are considered the ‘Short-term Move’. • 50 percent: Buy zone – look for 50 percent pullbacks of
the short-term move when there is a cluster of support/
Long-Term Move resistance at the same level.
All Fib lines must ‘end’ at the same point, you can, however, • 61.8percent: The buy zone – as with the 50percentlevel, you
‘start’ from different points, drawing to the same end point. should look to buy 61.8 percent pullbacks of the short-term
We refer to this as the long-term move. This is how you move but only when this level clusters with other support/
can locate clusters and is also how we start to build a high resistance at the same point. 61.8 percent is known as ‘The
probability entry point. Golden Ratio’ and is perhaps the most powerful of all Fib
retracement levels.
Locating Clusters of Support and Resistance • 78.6 percent: This level should not be used for entry and
Again looking at Figure 4, we know that the line has to be
drawn from D down to E as this makes sure we are only
trading a pullback of the current trend. This, however, leaves F6) Correct Using of Locating Fib Clusters
us with four potential retracement levels. To define a potential
entry point, we look to see if any Fib retracements cluster at the
same level. To do this, you must use a different start point for
your Fib line and finish at the same end point. See Figure 5
which shows the same chart as Figure 4, however this time we
are drawing a second Fib line from a different start point, C, and
finishing at the same end point, E. Note that the 38.2 percent for
the long-term move down (C to E) overlaps with the 50 percent
of the short-term move (D to E). This is what is referred to as a Fib
cluster and becomes a much higher probability turning point
if the price reaches there. The same is very true in an uptrend.
Refer to Figure 6 which shows a cluster of the short- term 50
percent and longer-term 38.2 percent. See Figure 7 to see what
happened when this level was tested.

Correct Usage of Each Fib Retracement Level

While there are many more Fib retracement levels, Precision Following on from figure 4, this figure shows the correct usage of locating Fib clusters, starting from the previous
traders only use certain levels and for various uses as follows: high and drawing to the same low. Note the point of cluster.
• 38.2 percent: By nature of the fact that we are looking for Source: www.tradestation.com

February 2010 | www.traders-mag.com 51

 TRADERS´STRATEGIES
F7) Market Bounces
Market bounces of the cluster illustrated in Figure 6.
Source: www.tradestation.com
is for stop losses only – your stop should be placed behind
the short-term 78.6 percent retracement level. The reason
for this is that the further the price pulls back, the higher the
probability that it is actually a reversal as compared to
just a retracement. Once the price pulls back over 78.6
percent, there is a far higher probability that it will actually
retrace the full 100 percent. Hence, a stop behind 78.6
percent protects your losses by having a slightly tighter
stop than using the 100 percent level. This equally results
in a more favourable reward-to-risk ratio.
• 100 percent: This means that the full move has reversed.
Use this for stops only in a situation where you would
like a slightly wider stop than the 78.6 or where the
100 percent adds significantly to the probability of your
trade, e.g. it is a major support level. Note that we do not
use the 23.6 percent pullback, this is simply too small a
pullback for a high probability entry point.
Fibonacci Retracement Trading Strategy
This analysis can be applied across any market and in
any time frame although it will work best on highly liquid
markets where there are many technical traders. Two
markets that match these criteria well are the large index
futures markets such as the mini S&P (ES) and mini Dow (YM)
and spot currencies.
Enter at the precise point of the cluster, i.e. as the price
touches it. Not before and definitely not after. Only trade
with the direction of the overall trend. Your confirmation is
the fact that you have a strong cluster within a strong trend.
Do not wait for the price to turn around at this level, by then
it is too late. If you wait for the price to do what you thought
it would, then you have missed the trade. We are using
leading indicators here to predict the move in advance. Your
stop loss should be placed behind the 78.6 percent retracement
level. More conservative traders could place their stop just
behind the 100 percent level but do not have a stop any wider
52 February 2010 | www.traders-mag.com
than this. Your target is the old high/low or the 0 percent level,
i.e. you expect the price to retest the extreme high or low A
further profit target for those who prefer to scale out of trades is
to use Fibonacci extension levels. The 127 percent extension is a
sensible next target.
Pullback Strategy Improvements
Other technical factors can and should always be considered
and this stands for any trading strategy that you employ.
Have as many reasons for entering a trade as possible! Some
areas to consider:
Trend
• Look for convergence and divergence between price
action and indicators to assess trend strength.
• Use trend following indicators such as the ADX or DMI.
• Assess trends in multiple time frames.
• Look for moving average buy & sell zones in addition to
Fib buy/sell zones.
Clusters of Support and Resistance
• Look for proven price action support and resistance at
the same levels, i.e. price has tested and failed at that
level before, adding further strength from non Fib users.
• Pivot points - the most powerful, individual technical
tool at a trader’s disposal. Find a pivot (or a cluster of
pivots) at the same point as your Fib cluster and you have
a VERY high probability trade. This forms the basis of the
Precision Trading Strategy. It also happens far more often
than you may think.
There are numerous ways to improve upon the success
of this strategy. There are many technical tools and strategies
out there and you can’t use them all but if you have
something that is working for you, keep on using it and use
it to add value to all trading decisions that you make. The
philosophy is quite simple – ‘Have as many reasons as you
possibly can for every single trade that you place’. The more
reasons you have occurring all at the same time, the higher
the probability of the trade being a success. To succeed as
a trader, that is exactly what you need… the confidence
in your strategy that you have more chance of winning
than losing. And of course the ability to execute precisely
according to your rules. Execute well! n
Nick McDonald
Nick McDonald is a full-time trader in addition to acting
as a mentor for aspiring traders. Nick founded Trade with
Precision to filter out unnecessary information from trader
training and instead focus on teaching people real trading
strategies that he himself uses to trade the markets daily.
You can find out more about upcoming workshops at
www.tradewithprecision.com.