Article

Fibonacci Retracements on the Mini Dow

Fibonacci Retracements ? A Precision Trading Strategy
Deciding on a topic for this article, I reviewed the top ranked articles in T2W and found some fantastic material. I did not however find inspiration for a new article idea that readers may like. Perhaps strangely, I then looked at the lowest rated articles. I noticed that two of them discussed Fibonacci which both surprised and intrigued me. It was not necessarily that people did not like Fib, just that perhaps it had not been explained well enough for their liking. I am a huge Fibonacci fan and it plays a big part in my trading so the following will explain how I use it to trade successfully.

While this strategy can be applied to almost any market, I will focus on the Dow Jones e-mini future, with all screenshots been the mini-Dow, (symbol YM) 1 minute charts.

Fibonacci ? Is it really so subjective?
No! Not once you know how to use it correctly. There is a precise place where lines should be drawn and many places where they should not be drawn. I have seen them drawn in crazy places by people who claim that Fib does not work. There are also precise retracement levels that you should look to enter at, levels that you should use as a guide only and levels that will help you place stops.

What I am teaching is not from a book and it?s not scientific (not that I know of anyway). It is simply the way that I have come to use Fibonacci retracements after many hours of screen time and it has added significantly to my trading ability after learning how to use it this way. I truly hope that it will assist you with your trading in a positive manner.

This article aims to dispel some of the myths surrounding Fib by showing how it can be used to trade the markets profitably & precisely, not subjectively as so many people seem to think.

You will learn:

  1. How fib is used objectively every time we draw a line 
  2. Exactly where to draw lines from (Start point)
  3. Exactly where to draw lines too (End point)
  4. Which of the Fibonacci retracement levels should be used as entry points and which should be used as guide to direction only or a stop loss
  5. A trading strategy with precise entry, stop loss and targets

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?. As the market starts to retrace, traders draw a Fibonacci line in the direction of the trend to see where the market might retrace too. This results in a series of 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 38.2%, 50%, 61.8% and 78.6%. This means that after a move in either direction, equalling 100%, the retracements may be 38.2% or 50% or so on, back in the opposite direction of the 100% move. I.e. If the full move reversed then this would be a 100% retracement.


caption: Figure 1 – Fibonacci Retracement Ratios

The problem is that as the price retraces, there can be five or more retracement levels of possible support/resistance. How do you know which level the market is most likely to turn at?  More importantly, where is a good place for you to enter a trade?  The answer is you don?t know yet; there is no high probability trade with only this amount of analysis.

This has led a lot of people to say that Fib is subjective and they argue the point valiantly. 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 virtually useless (IMHO) trading tool.

So, lets 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?

Trend Analysis
Simple trend analysis is perhaps the most straightforward, most important and yet most over-looked technical tool at our disposal. Time and time again I meet traders who skip over it because they think higher highs and higher lows it is ?too simple?. They think the advanced stuff (such as Fibonacci) is what will make them more money. This could not be further from the truth!  Without a grasp of the basics, the advanced stuff never quite makes sense either.  Correct trend analysis is, in my opinion, the most important thing that a trader can ever understand. It is also necessary for drawing Fib lines correctly (no wonder so many people think Fib is subjective when so many don?t yet understand trends).

An uptrend is:

  • A series of higher highs (HH) and higher lows (HL). See 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)


caption: Figure 2 – Uptrend

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)


caption: Figure 3 – Downtrend

Where the Fib line should Start from
Firstly, you should only draw a Fib retracement level when there is a trend. All trends have to retrace in order for the above definitions to be true i.e. in an uptrend price has to pullback from a HH to make a HL. You are always looking for a retracement of the current trend which ensures you have momentum behind the move. If there is no clear trend then by using Fib retracements you are swimming against the tide even 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 around 100% of each prior move. 

Now that you are trading with the trend, you should start your Fib line from a HL within an uptrend or a 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 downward in the direction of the trend. 

The most important place to start from is:

  • The most recent low within a current up-trend.
  • The most recent high within a current down-trend

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 timeframe you are trading.  For example, look at figure 3. We have now reversed the downtrend and are uptrending (made a 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.

Where the Fib line should End
This is the part where people most often get it wrong.  There are highs and lows all over the chart so which one do you use?  The answer is in fact 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

Hence, if there is no 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 completely 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.


caption: Figure 4

To confirm:

To confirm: Short term move
? Within an UP trend, you MUST always draw your Fib line starting from the most recent low and finishing at the most recent high
? Within a DOWN trend, you MUST always draw your Fib line starting from the most recent high and finishing at the most recent low
? Both of the above are what I refer to as the ?Short-term Move?

Long term move
All Fib lines must ?end? at the same point, you can however ?start? from different points, drawing to the same end point. This is what I will refer to as the long-term move. This is how we locate clusters and is also how we start to build a high probability entry point?

Locating clusters of Support and resistance
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 us with four potential retracement levels. To define a potential entry point, we must 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% for the larger move down (C to E) overlaps with the 50% of the short term move (D to E). This is what is referred to as a Fib cluster and become a much higher probability turning point if the price reaches there.


caption: Figure 5

The same is very true in an uptrend. Refer to figure 6 which shows a cluster of the short term 50% and longer term 38.2%. See figure 7 to see what happened when this level was tested.


caption: Figure 6


caption: Figure 7

The retracement levels and their correct usage
While there are many more Fibonacci retracement levels, the ones that you should use are as follows:

38.2%
By nature of the fact that we are looking for clusters for an entry point, the 38.2% will only be used for the long-term move. E.g. a 38.2% move for the longer term may cluster with the shorter term 50% or 61.8% level.

50%
The buy zone ? look to buy 50% pullbacks of the short term move when there is a cluster of support/resistance at the same level.  Granted, 50% is not actually a Fib number to the best of my knowledge. However it works well and it works often. 50% represents the point of equilibrium between buyers and sellers within a trend.

61.8%
The buy Zone ? as with the 50% level, you should look to buy 61.8% pullbacks of the short term move but only when this level clusters with other support/resistance at the same point. 61.8% is known as ?The Golden Ratio? and is perhaps the most powerful of all Fib retracement levels.

78.6%
This level should not be used for entry.  Rather your stop loss should be placed behind the short term 78.6% 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 a retracement. Once the price pulls back over 78.6% there is a far higher probability that it will actually retrace the full 100%. Hence, a stop behind 78.6% protects your losses by having a slightly tighter stop that using the 100% level.  This also results in a more favourable reward to risk ratio.

100%
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% 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% pullback, this is simply too small a pullback for a high probability entry point.

Trading Strategy
I use one minute charts on the mini Dow future (YM) as the short term trends are clearer but it does not really matter what you use.  For example I trade the same strategy on Forex with 15m charts and regularly analyse daily charts across a range of markets using the same technique.  Another reason I prefer the 1m chart on the Dow is that I predominantly trade the US open from 2:30pm GMT. While you may of course look at 2, 5 or 15 minute charts, the trends will be less clear and take longer to develop once the market opens. A 1m trend becomes clear very quickly and thus suits my timeframes.

Entry
Enter at the precise point of the cluster i.e. as the price touches it.  Not before and not after.  Only ever 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.

Stop
Your stop should be placed behind the 78.6% retracement level.  More conservative traders could place their stop just behind the 100% level but do not have a stop any wider than this.

Target
Your target is the old high/low or the 0% retracement level. I.e., you expect the price to retest the extreme.

A further profit target for those who prefer to scale out of trades is to use Fibonacci extension levels.

Improvements

Other technical factors to consider:

Trend Improvements
? 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 timeframes

Cluster Improvements
? Look for proven price action support and resistance at the same levels i.e. price has tested and failed at that level before
? Pivot points ? a topic for another article perhaps. In my opinion pivots are the most powerful, individual technical tool at our disposal. Find a pivot at the same point as your Fib cluster and you have a VERY high probability trade. This forms the basis of what I call my Precision Trading Strategy. It also happens far more often than you may think.

There are various ways to improve upon the success of this strategy even further. There are thousands of technical tools out there and we can?t use them all but if you have something that is working for you, keep on using it. The Precision Trader 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 been a success. At the end of the day that is all 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. Happy trading and best of luck for a very prosperous 2008!

Nick McDonald is an independent fulltime trader as well as a mentor in foreign exchange & Dow Jones futures trading strategies. Through his company, Precision Trader, Nick aims to cut through the nonsense and teach people real trading strategies in a practical trading environment, omitting irrelevant information that is not conducive to trading successfully.  Nick was the featured trader in Traders Mag in November 2008 and is a regular author for the magazine.  Nick has also worked with many major brokers and their clients worldwide, passing on his trading knowledge & skills. You can find out more at www.tradewithprecision.com.

rols

Well-known member
Sep 10, 2004
1,621
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#2
This is a forum thread for discussing the Knowledge Lab Article, "Fibonacci Retracements on the Mini Dow".
This is a well written article.

The only thing it doesn't mention is the slightly important fact that old Leonardo of Pisa was an eleventh century mathematician who used the Fibonacci sequence (which incidentally wasn't his invention) to solve a problem concerning the population of rabbits.

Rabbits bonking to trading the Dow Jones e-mini could be described as a quantum leap.
 

dick_dastardly

Well-known member
Jun 28, 2003
843
152
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#3
I've noticed that every once in a while the debate about fibs pops up here on t2w.

Non-believers will say something like

" fibo traders are just kidding themselves and making fibs fit in hindsight "

or

" there's so many fib levels that price is bound to turn at or near one of them "


Whilst supporters will come back with something like

" Look ! here's a chart, that fib there is a near perfect xx fib, how can it be coincidence ? "


Everyone seems to be arguing if they exist but no-one seems to want to say why they exist.

Those that subscribe to fib theory will say that fibs occur at this level or that level but they never seem to actually explain why they believe fibs occur at 38.2% or 50% or 61.8%.

Is it just they've seen retraces unfold to the same levels over and over again that they blindly accept these levels exist without knowing the reasons why or is there some underlying process/mechanism that fibo fans believe to be at work ?



dd
 

Splitlink

Well-known member
Nov 18, 2001
10,850
1,231
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#4
I've noticed that every once in a while the debate about fibs pops up here on t2w.

Non-believers will say something like

" fibo traders are just kidding themselves and making fibs fit in hindsight "

or

" there's so many fib levels that price is bound to turn at or near one of them "


Whilst supporters will come back with something like

" Look ! here's a chart, that fib there is a near perfect xx fib, how can it be coincidence ? "


Everyone seems to be arguing if they exist but no-one seems to want to say why they exist.

Those that subscribe to fib theory will say that fibs occur at this level or that level but they never seem to actually explain why they believe fibs occur at 38.2% or 50% or 61.8%.

Is it just they've seen retraces unfold to the same levels over and over again that they blindly accept these levels exist without knowing the reasons why or is there some underlying process/mechanism that fibo fans believe to be at work ?



dd
Fibs are no different to the bell curve in the fact that they show, over a period of time, where the maximum number of trades have taken place. It all comes down to the main decision to be made, Which way is the trend direction? Get that right and you are home and dry. The bell curve, as in Market Profile, will get you into the market on the correct side if you know that direction.

Fibs are no different. Get it wrong and that is that. Have tight stops.

If statistical data gives more accurate readings, the larger the population, with a recommended minimum of 100, why should a Fib reading covering 20-30 bars give accurate readings? I can't see it, but people draw these Fib lines everywhere they see a trend, regardless of how many bars there are.

Split
 

darktone

Well-known member
Nov 2, 2003
3,917
999
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#5
What I like about fibs are they give a black and white level to act on in the smaller time frames. Notice this guy is using them on 1 min charts! Id have thought that utter madness at one point! Not so sure anymore. Gauge direction from larger time frames, (d /4hr / 1hr). Use the smalls when the PA lines up (1min / 5 min) and fibs to take position. Use (d /4hr / 1hr) to run position.

You can get some serious size on this way and providing you use tight MM risks can be kept in check.

I dunno about all this 61.8 being the formula for the universe stuff! But its 61.8% better than trading the BO! :p
 

Splitlink

Well-known member
Nov 18, 2001
10,850
1,231
223
#6
What I like about fibs are they give a black and white level to act on in the smaller time frames. Notice this guy is using them on 1 min charts! Id have thought that utter madness at one point! Not so sure anymore. Gauge direction from larger time frames, (d /4hr / 1hr). Use the smalls when the PA lines up (1min / 5 min) and fibs to take position. Use (d /4hr / 1hr) to run position.

You can get some serious size on this way and providing you use tight MM risks can be kept in check.

I dunno about all this 61.8 being the formula for the universe stuff! But its 61.8% better than trading the BO! :p
They are more likely to be accurate with 1' bars than with longer time frames because there are more bars in the time period that he is, probably, using. 60 per hour, for example- It is, also, likely to wipe out the after hour trading period, which is useless, anyway.

How many people include the overnight period in their Fib lines? A lot. I bet. What happens during the night gives a strong bias to the calculation, IMO, but nevertheless some traders will draw, on an hourly chart, a Fib line covering several overnight periods which are, simply, wrong because no trading was done.

I'm not an expert on this and could be wrong about what I have said but a bit of thought has decided me against using them. Far better to draw in your own RS lines.

Split
 

darktone

Well-known member
Nov 2, 2003
3,917
999
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#7
They are more likely to be accurate with 1' bars
More accurate!? hmm. Just more of id say.

It is, also, likely to wipe out the after hour trading period, which is useless, anyway.
The thinking i put forward is to attempt entries when smalls are running in the same direction as your main tfs. Ie Your market is downtrending! Your hour chart has retraced to the previous 4hr high and is starting to show weakness. Then may be a good time to attempt getting size into a short via the smalls.

How many people include the overnight period in their Fib lines? A lot. I bet. What happens during the night gives a strong bias to the calculation, IMO, but nevertheless some traders will draw, on an hourly chart, a Fib line covering several overnight periods which are, simply, wrong because no trading was done.
Stocks yes..Fx no. But i was suggesting only using in the smalls anyway. To be fair i cant see the use for fibs in the larger TFs (in general).

Far better to draw in your own RS lines.
S&R Rules!! :)
 

fibonelli

Well-known member
Oct 1, 2006
1,338
288
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#9
A very clear and concise article on how to correctly apply the fibonacci retracement tool. Also good to see the importance of confluence and of techniques to determine the probability of a trend continuing in the article.
 

nkruger

Active member
Nov 9, 2006
855
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#10
Good article Nick. Clear and concise explanation. If you newbies out there are designing a trading system, consider using this.
 

JC1

Member
Oct 10, 2006
1
0
11
#13
Very good article, 'precisely' explains the con cept of fibs and its correct usage. Well done Nick!

Look forward to your article on Pivot Points - soon.
 
May 9, 2017
1
0
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#15
Hi. Should't it be "point B" in "the only place to do it would be with the uptrend from the last LL up to point A" in page 2? Sorry if I missunderstand. I've been in the market for 5 days.

LE. "point A" is correct because "Within an UP trend, you MUST always draw your Fib line starting from the most recent low and finishing at the most recent high". Got it.