Learning Fibonacci Retracements
Many traders and investors use Fibonacci ratios to project future levels of support and resistance calculated on previous price moves in forex markets. In simple words, past price movements in the forex market determine where the Fibonacci levels will be calculated.
Fibonacci analysis is used in determining and identifying the support and resistance levels during both the trend retracement and the trend continuations. It is based on a number of ratios derived from the Fibonacci sequence. This interesting and remarkable sequence was discovered by an Italian mathematician Leonardo Pisano in the 13th century.
The sequence starts with 0, 1 and 1. The next number in the sequence is determined by adding the previous two numbers. For example, if you take the first two numbers 0 &1, the next number will be 0+1=1. If you take the next two recent numbers, 1 & 1, the next number will be 1+1=2. So the Fibonacci sequence takes shape like this: 0,1,1,2,3,5,8,13,21,34,55.
The remarkable thing about this sequence is that the ratio of number at specific intervals would consistently be the same, no matter how high you count the numbers. Fibonacci sequence gives us two very important ratios. These two ratios appear over and over again in nature such as sunflowers, shells, pine cones etc. These two ratios also appear in forex markets.
The first ratio is 38.2%. It is calculated by dividing any number in the Fibonacci sequence by the number two places higher in the sequence. For example, in the above Fibonacci sequence, divide 21 by 55 (55 is two places higher than 21) you get 21/55=38.2%.
The second important ratio is 61.8%. It is obtained by dividing any number in the Fibonacci sequence by the next number in the sequence. For example, divide 34 by 55 (55 is the next number after 34), you get 34/54=61.8%.
Forex market trends dont go exactly in a straight line, up trends never go straight up and down trends never go straight down. The price will always trace along the way as buyers and sellers enter and exit the markets, the important question in every investors mind is how far these retracements will penetrate into the previous price movements. This is where the Fibonacci ratios are extensively applied and used.
Most forex traders use the three additional ratios of 0%, 50% and 100% in conjunction with the two primary Fibonacci ratios to round out the retracement analysis tools. Two secondary Fibonacci ratios, 161.8% and 261.8% are also used in the trend continuation projections. The ratio 161.8% is obtained by dividing any number in the sequence by the number preceding it. For example, in the above sequence dividing 55 by 34 gives 55/34=161.8%. Similarly the ratio 261.8% is obtained by dividing any number in the sequence by the two preceding it. For example, divide 55 by 21, you will get 55/21=261.8%.
Fibonacci ratios are used by currency traders and investors in making entry and exit decisions for each trade. The first ratio 38.2% is used as an entry point in a trending market. The ratio 0% is used as the exit point. The question that you may ask is what the reason markets react to these levels is. You should not forget currency markets are just investors and speculators buying and selling currencies. So if many investors and speculators start believing in a thing, it starts becoming a self fulfilling prophecy. As most of the investors use Fibonacci analysis in determining the support and resistance and placing there entry and exit orders based on these ratios, the markets starts reacting to these levels.
How to Identify Breaking Support and Resistance?
Support and resistance levels are used by investors and speculators to determine how far they believe a currency pair will move between the two levels. This also tells them at what points the price action may turn around due to the buying or selling pressure and start moving in the opposite direction.
Sometimes, the markets change direction due to a shift in some underlying fundamental factor. The market change of direction due to the shift in underlying economic factors is strong enough to cause a currency pair to break through a previously established support and resistance level. When a previous support and resistance level is broken by the markets, new support and resistance levels are established. However, the broken levels may still have some influence on the market in the future.
Sometimes there are attempted breakouts, this is also known as False Breakouts. With experience, it will become clear to you that prices do not always stop at exactly the same points each time. So if you are going to use strict requirements for your support and resistance, those levels may not hold up every time. This way, you are going to fake yourself out of a lot of valid price movements.
Even when you take all the precautions with your support and resistance levels, you may fall victim to a false breakout. Now, you will ask how I can tell when the price has truly broken through support and resistance in a new direction.
There are primarily two methods that you can use to filter out a false breakout with a true breakout. These two methods are setting price-amplitude benchmarks and identifying role reversals.
Setting price amplitude benchmarks involves analyzing a chart to see if you can identify any moments when the price momentarily poked through the prevailing support and resistance level before pulling back and once again adhering to the previous level.
The dips through the predetermined levels are usually short lived. You can draw a secondary support and resistance lines which you can then utilize as your price-amplitude benchmarks.
A price amplitude benchmark tells you that if the price breaks through the predetermined level but does not break through the benchmark, you dont need to worry about a change in the direction of the trend. However, if the price has enough momentum to breach the benchmark, it has a good chance of continuing in the new direction.
Identifying role reversals method involves watching the price action to see if support levels turn into resistance levels and resistance levels turn into support levels. Often, you will see the price action bounce off a level of resistance, then turn around and start heading lower and bounce off the previous resistance level.
When a resistance level is broken, that same level will turn into a support level. Conversely when a support level is broken, that same level will turn into a resistance level. What this tells is that you can use both the benchmark and the role reversal confirmations in your trading analysis.
Support and Resistance Levels in Forex Trading
Learning technical analysis will give you the edge as a forex trader. It will develop your confidence in your ability to predict what will happen in the markets in the future.
But the most important drawback with most of the technical indicators is that they lag behind the markets. Lagging means part of the price action has already taken place before the movement is reflected by these technical indicators.
However, support and resistance levels especially those based on Fibonacci levels are considered to be leading indicators because they lead the markets in predictable paths. Now, when we say predictable, it does not mean guaranteed. But it can be pretty close.
Support is the price level that a currency pair has trouble breaking through to the downside. Support is also referred to as the floor of the currency pair price movement.
Resistance is the price level that a currency pair has trouble breaking through to the upside. Resistance level is also known as the ceiling of the currency pair price movement.
Many new forex traders find it surprising that there is a strangely predictable and reliable price action that takes place at the support and resistance levels. Most of the time, they will find the price action oscillating between the support and resistance levels.
Why it is that majority of the people begin buying and selling at the given support and resistance levels. There is nothing on the charts that forces the people to do so.
A simple explanation is this that majority of the forex traders think the support level as the best price available to them and considers it an excellent opportunity to buy once it reaches the support level.
Similarly, at resistance, majority of the currency traders think that currency pair is not favorably priced and has become overpriced. So they consider it as an excellent opportunity to short the pair.
You will have an edge and an advantage in your currency trading if you are capable of accurately identifying and predicting the support and resistance levels in the markets. As more and more traders use technical analysis in trading and calculate the support and resistance levels, the more these levels become self fulfilling prophesies.
One important indication of support and resistance levels is that price level is reached a number of times but it is never breached. Support and resistance levels can be horizontal for a ranging markets or they can be sloping up or down for a trending market.
What happens at the support level is that as traders begin to sell the currency pair and take profit, the price of the currency pair starts to drop down. As the price starts to fall, other forex traders who were interested in buying the currency pair watch how far it will go down.
Most of them have done their calculations as to how far the price level will drop down before they can go long. Past price action tells them that the price offered at the support level is the best price under the present market conditions. So when it reaches that level, most of them start buying and go long.
When there are more buyers than sellers, the price of the currency pair starts to rebound and rise. It rises till the resistance level determined by most of them when majority decide that the currency pair is now over priced and start selling.
This oscillating price action keep on repeating itself until and unless there is a fundamental shift in the markets that forces new levels and a new direction.
Trading Price Action in Forex Markets
To become a successful trader if you are new, you should immerse yourself completely in the subject in order to find your edge. If you already a winning at trading than you should know exactly what your edge is.
Even the most advanced traders find it difficult to understand, interpret and trade the sharp moves often seen in the forex markets. By learning to read and interpret price action, you can develop a huge advantage for you as a trader.
In a steep decline, one should be careful to measure the reaction of the longs. You must know if the move has the chance to turn into a rout.
You should look at the reaction of the longs as soon as the rate begins to go south, this way you will be able to determine if the market is sitting on a large number of long positions and whether traders want to dump their positions. In case of a spike followed by a sharp V recovery, you should avoid shorting the pair.
Masses of buyers entering the market at lower levels tell you that the market is not particularly long. Lower prices mean bargain prices for those wishing to accumulate long positions.
Moving averages (MAs) are among the oldest, true and tested indicators. Widely used moving averages are the 50, 100 and 200 day MAs.
As said before, moving averages are lagging indicators. They relate with the past price action in the market. MAs can be used effectively in intra-day trading for entering and exiting positions in one way markets that are trending.
During times of sharp price moves, it becomes difficult for the traders to enter a position as retracements are far and few. This makes most of the traders confused and forces them to start taking arbitrary decisions.
MAs can be used as dynamic resistance levels in such situations. This can give better results than the static support/resistance levels used by majority of the traders.
The advantages of using Moving Averages like this gives you dynamic levels to trade off and gauge price action taking place in the market. This will help you avoid using arbitrary levels in entering or exiting a position.
Learn to Trade like a Hedge Fund Manager (Part I)
The difference between a professional trader and an amateur trader is that a professional trader never goes into a trade blindly. You see hedge fund managers have to show good results to their investors in order to solicit their investments into their funds. Hedge fund managers have to convince their clients that they have a battle tested strategy.
As individual traders, our $20,000 trading account is as important as any $20 million hedge fund. Our $20,000 account is more important. We are using our own hard earned money on trading. A hedge fund manager is most probably trading with other peoples money.
Most of the hedge fund managers follow a step by step process to develop their forex trading strategies. There is no reason why should we as individual traders also not follow that step by step process to develop our own trading strategies. We cant afford to lose our hard earned money in unsuccessful trading.
One thing should be clear; every trader has to find his/her own edge. We can learn from others. But in the end, it is our own methods and insights that will make us succeed as forex traders in the long run. Lets discuss the step by step process of developing our own trading strategy like the hedge fund managers.
Start by properly defining your trading strategy. Every hedge fund manager like every individual trader follows a different methodology. Some traders use fundamental analysis. Other traders use technical analysis.
The first thing that you should understand is what type of currency trader you can be and what style of trading best suits you. Are you comfortable as a day trader? Do you want to be swing trader or position trader?
From the start, figure out whether you want to trade based on fundamentals or technicals or a combination of both. Hedge fund managers develop their trading strategies by defining clear cut trading rules and coding them. This way the hedge fund managers avoid the pitfalls of emotional trading.
Trading based on emotions is dangerous and will ruin you as a trader in the long run. Make your forex system rule based and mechanical with clear cut steps that you will follow in order to make your trading as unemotional as possible.
Some trade news. You should decide if you want to be a news trader. Whether you will use technical indicators in your trading, there are many so which ones and how! There are many currency pairs. You cant trade all of them. You need to pick a few favorite currency pairs. All currency pairs are not equal. You need to focus on only a few to become a successful trader.
Every currency pair requires a different strategy to succeed. You need to understand this. Some strategies work best on some currency pairs but dont work on others. Read more in Part II of this article.
Fundamental Trading Strategy Based on Interest Rate Differentials
As a forex trader, you should be aware of the role played by the interest rate changes in the general economic and investment climate. You should know that interest rates are an essential part of investment decisions and can drive currency markets as well as the stock and commodities markets in either direction. After the unemployment figures, Federal Open Market Committee (FOMC) rate decisions are the second largest currency market moving release.
The impact of the interest rate changes not only have short term consequences but also have long term impact on the currency markets. One Central Banks decision can affect more than a single currency pair in the interconnected forex markets.
In forex trading, an interest rate differential is the difference between the base currency interest rate and the quoted currency interest rate. In the currency pair, EUR/USD, EUR is the base currency and USD is the quoted or counter currency. The interest rate differential for the EUR/USD pair will be the difference between the Euro interest rate and the USD interest rate.
Understanding the relationship between the interest rate differentials and the currency pairs can be very profitable for you as a forex trader. In addition to the Central Banks overnight interest rate decisions, expected future overnight rates as well the expected timing for the interest rate changes can be crucial to the currency pair movements.
The reason why this is profitable is that international investors like big banks, hedge funds and institutional investors are yield seekers. They actively keep on shifting funds from the low yield assets to high yield assets.
Interest rate differentials are considered to be the leading indicators for currencies. London Inter Bank Offer Rate (LIBOR) and the 10 year government bond yields are usually used as leading indicators of currency appreciation or depreciation.
Lets take an example, suppose the Australian 10-year government bond yield is 5.25%. The US 10-year government bond yield is 1.75%. The yield spread in this case would be 350 basis points in favor of the Australian Dollar.
Suppose the Australian government raised its interest rate by 25 basis points. The 10 year Australian government bond yield would also appreciate to 5.50%. Now, the new yield spread is 375 basis points in favor of AUD. The AUD will also be expected to appreciate against USD.
The general rule of thumb used by professional traders is that when a yield spread increases in favor of a certain currency that currency is expected to appreciate against the other currency in the pair. This is important information for you as a trader. Interest rate data is available on Bloomberg. Keep track of the currencies in the currency pairs that you trade with that data.
Understanding How the Forex Brokers Make Profits
When you start currency trading, you are told by every forex broker that there are no commissions involved in forex trading. New traders take their brokers words as true and most think that the cost of trading is minimal.
Forex brokers are also known as FCMs (Futures Commission Merchants). They make profits through the bid/ask spread they charge their clients for each currency pairs. This bid/ask spread is your trading cost and profit for your broker.
Lets do a simple calculation. Spreads are usually overlooked by the individual traders as the price they pay for trading. So lets calculate your cost of trading.
Suppose you are day trading. 5 times every day, taking away the weekends, when you cant trade, there are 250 trading days for you.
As a day trader, you will open and close your position before the end of each trading day. That means each position is traded 2 times by you.
Suppose; your start with a deposit of $50,000. You use a leverage of 4 only, you are being cautious. So this $50,000 deposit will control (50,000) (4) = $200,000.
Your Annual Turnover will be; (5) (250)(2)(200,000)= $500 M. Huge! Now lets calculate how much your broker will make and what your spread cost is. Spread Cost= (Annual Turnover) (spread)/2.
Suppose further, the bid/offer spread charged by the broker is 3 pips. 3 Pips Spread Cost= (500M) (0.0003)/2= $75,000.
Suppose, the spread offered by the broker is only 2 pips. 2 Pip Spread Cost= (500M) (0.0002)/2= $50,000.
You can see yourself, the cost of trading with a 3 pips spread versus a 2 pips is $25,000. This is 50% of your account equity. You see, a 1 pip difference can result in $25,000 more as trading cost for you.
You will have to make a profit of $75,000 simply to break even. Trading costs are one of the reasons most active traders fail in the long run.