What is Our Favorite Fib?

• A Fibonacci-based strategy that takes advantage of the momentum
• can be used on various time frames and markets: FX majors, stock indices and commodities
• could be used at the earlier stages after some major economic news 
• won’t work as well if the news merely causes a corrective rally or sell-off inside an established trend
• suitable for markets that are in a clear strong trend: when the price is making fresh all-time or multi-year/month highs or lows.

Time Frame

The higher the time frame, the more effective the F/F strategy works. It is typically used on 1 or 4 hour time frames, although sometimes it could be applied to the daily time frame, too. The shortest time frame that one can use this strategy is about 15 minutes. However, if the trade is based on a higher time frame, then it is a good idea to zoom in to a 5-minute chart in order to refine entry.

Components of the strategy

The F/F strategy is based on some Fibonacci retracement and extension levels. These are the 38.2% and 50% retracement levels (the latter, in fact, is not a Fibonacci level), and the 127.2%, 161.8% and 261.8% Fibonacci extension levels.

To understand how the strategy works, let’s say that following a strong upward move (e.g. from point A to B), the market retraces a little (to point C) because of profit-taking and/or top picking, before continuing in the original direction (beyond point B). This strategy requires 3 price swings – the move from point A to B, B to C (correction), and C to D (extension). Here is how an F/F buy strategy would typically look like:

In the F/F strategy, we are interested in some parts of the CD leg of the move – the bit beyond point B, where entry is based. The profit target would be determined by a Fibonacci extension level of the BC move (more on this below).

One condition for this strategy to work well is that we need momentum. By definition, this implies point C should represent a shallow retracement of AB, and then a continuation in the original direction, beyond point B. Therefore, if price retraces more than 50%, or too much time elapses before it breaks point B, then the entry signal would not be valid.

In other words, for optimal entry signal, we need a strong move from point A to point B; a relatively quick and shallow retracement of less than 50% to point C, and then a continuation towards point D.

Once point C is established, all of the strategy’s parameters can be determined. Before discussing the entry and closing levels in detail, here are a few examples of how the strategy would work:

Example 1: Buy NZD/USD
Before:

After: Target reached

Example 2: Buy GBP/USD ahead of a key economic release
Before:

After: Target reached

(note that the 261.8% extension could have been a better target, in this case)

Example 3: Sell Brent crude oil

After: stopped out

(due to false breakout and/or premature entry)

Example 4: Buy gold

After: invalid

(rally lost momentum; 50% level was breached)

Entry

The entry would be based on break of point B and the objective is to ride the move towards point D – which would be a Fibonacci level, determined by the BC swing.

For a buy (sell) trade, the entry could be via a stop buy (sell) order a few pips/points above (below) point B, or alternatively it could be via a market/limit buy order once point B is broken.

• Entry via a stop order ensures the trade would be triggered. However， in the case of a false breakout, it could mean buying (selling) right at the high (low). What’s more, if the market gaps, the entry may not be at the same level as the one the trader had chosen.
• Entry via a market or limit order allows the trader some time to determine whether or not the breakout above (below) point B is genuine or false. If price holds above (below) point B for say a few minutes, then the trader may wish to buy (sell) at the best available price. However， the risk is that the market moves quickly towards the target without a pullback, and the trader misses the opportunity.

If the entry is based on a higher time frame like the 4 hours chart, the trader may wish to hold fire and zoom into a 5 or 10 minutes chart and wait until price closes above (below) point B on the lower time frame before buying (selling).

Stop loss

For a buy (sell) trade, the stop loss would be some distance below (above) point B, ideally below (above) a small fractal within the larger swing. The maximum distance between the stop loss and entry should be less than the distance between entry and the profit target. In other words, the risk to reward ratio should be better than 1:1 (ideally 1:2 or superior).