My Approach to Forex Trading: #2

…(and a brief discussion about Fibaoncci retracements for binary options trading)

I would like to cover a recent spot forex trade that I took and one that I happen to currently be in at the very moment. As I mentioned in my first spot forex trading article, I rely on Fibonacci retracements heavily in FX trading.

On my current USD/CHF chart, I have two Fibonacci retracements drawn in. One on the monthly chart – the first goes from 0.70675-1.83130. That move encompasses roughly eleven years of price data. For those of you familiar with the USD/CHF, the fact that this pair was once above the 1.8000 level might seem strange, as it’s basically been below the 1.0000 parity level for a few years now. That high of 1.83130 was reached way back in October of 2000. The other is a shorter price leg I have drawn in from that same multi-year low spot of 0.70675 up to the test near parity, 0.99710, in June of 2012.

Understandably, when drawing in Fibonacci retracements, one might be confused as to where to draw them, as there’s so many peaks and troughs on a chart that could characterize a sustained price move. What I do is simply look for the most significant ones way out on the monthly and weekly timeframes, preferably ones that encompass multi-year highs and lows, such as the ones I have drawn in on the USD/CHF. I feel that these are the most important, because it’s the banks and big-money institutions in the world that determine where these markets will go. And they happen to use tools like Fibonacci retracements over large sets of price data to make their buy and sell determinations.

Like I’ve mentioned in previous articles, there is no fundamental reason why things like Fibonacci retracements, daily pivot points, and basic support and resistance created by previous price history tend to hold when the markets reach these levels. They don’t reveal some magical underworking of the financial markets. It’s essentially a self-fulfilling prophecy – they tend to work a sizable fraction of the time simply because enough money dictates that they do so. As a retail trader, whether you’re trading forex, binary options, vanilla options, equities, or whatever, it should always be your job to try and get inside the minds of the big players who control these markets for optimal results and continued success.

Now if you’re a short-term binary trader, putting these Fibonacci retracements on your USD/CHF chart might not necessarily be highly productive, because you’re likely to encounter a trade with these levels only once in a blue moon. Months could go by without price encountering these levels for the simple fact that they’re spaced so far apart considering they encompass multi-year periods of price data.

For typical binary options trading – i.e., trading off the five-minute chart – choosing major price moves off the daily time compression might be a better strategy. I know some traders like to plot Fibonacci retracements on even smaller timeframes – like the hourly chart or even 15-minute chart. That can be effective for helping you find potential price reversal areas. But just remember the lower the timeframe, the less effective these retracement levels are going to be simply because they don’t account for a very large amount of overall price data in the market. And as always, in binaries I never recommend just trading the level just because the market gets there and you might be afraid that you’ll miss out on a trade if you don’t act right away.

With that said, I’ll introduce my current USD/CHF forex trade. As always, I trade forex from the daily chart, as this allows me to check my charts just once daily (pretty simple and relatively stress-free given I have a full schedule), gives a larger macroscopic view of the markets (i.e., each candle encompasses the entire world’s daily opinion), and also cuts down on commission costs by avoiding frequent trades. Trading larger price movements also marginalizes the 2-3 pip spread placed on each trade.

I was using the 61.8% Fibonacci retracement level here for this trade, 0.88618. This was a level that hadn’t been touched in over a year, so I felt pretty confident that the market would show some sort of bounce off of such a robust Fib level. When markets hover around a level for large periods of time, you’ll usually see a progressive lack of sensitivity to it. That certainly wasn’t the case here so I had a limit order set right at the 0.88618 level, with a stop-loss set just below the 0.8800 whole number at 0.8790.

Stop-losses should always be set to a level where you’d be confident that your reasoning for entering the trade would be invalidated. A stop-loss of over seventy pips might seem like a lot, but I’m definitely a believer in letting a trade have some breathing room to develop. Having a stop-loss of say twenty pips, in this case, wouldn’t be a very shrewd decision, as you don’t want to be prematurely stopped out by not giving your trade much of a chance to work out in the first place. But a southward break of 0.8800 to me would signal that my educated guess of 0.88618 acting as a support level would be incorrect, as whole numbers themselves are frequently referred to and act as “psychological support/resistance.” A break of that would tell me that a northward climb back above the Fib level would be quite unlikely and therefore would represent a reasonable termination point for the trade.

I had a take-profit level of 0.9000. This gave a solid reward-to-risk ratio of roughly 2:1, which is what I like to aim for at minimum. The price of 0.9000 can be an especially strong psychological resistance point due to it being a multiple of ten (e.g., 0.8000, 0.9000, 1.0000, etc.). Therefore I felt that this was a good potential stopping point for this trade. Some traders might using scaling techniques, where they might cut half their position once it hits a take-profit level and let the remainder run. But I don’t like things to be that complex personally. I just like to invest fixed amounts and either be all-in and all-out of a trade.

This trade worked out very well. It triggered on December 10. But for the first week it did essentially nothing, giving a minor bounce before returning back to around entry level. But on December 18, I saw nearly 100 pips go in my favor followed by another 42 pips or so on December 19, leaving me twenty pips shy of my take-profit level. I was able to get those final twenty pips on December 20 and collect 137 pips of total profit altogether (accounting for the spread, as well). Not surprisingly, 0.9000 was promptly and sharply rejected, and I barely was able to hit that take-profit level as 0.90003 was the daily high. That might seem like a matter of luck, but in all honestly it was merely a matter of sheer expectation that 0.9000 would see a touch and prompt rejection. This is particularly true in the sense that we’re essentially in a downtrend with this pair at the current moment.

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