How to Use Fibonacci Retracement to Enter a Forex Trade

The first thing you should know about the Fibonacci tool is that it works best when the forex market is trending. The idea is to go long (or buy) on a retracement at a Fibonacci support level when the market is trending up, and to go short (or sell) on a retracement at a Fibonacci resistance level when the market is trending down. Finding Fibonacci Retracement Levels In order to find these Fibonacci retracement levels, you have to find the recent significant Swing Highs and Swings Lows. Then, for downtrends, click on the Swing High and drag the cursor to the most recent Swing Low. For uptrends, do the opposite. Click on the Swing Low and drag the cursor to the most recent Swing High. Got that? Now, let’s take a look at some examples on how to apply Fibonacci retracements levels to the currency markets. Uptrend This is a daily chart of AUD/USD.

Here we plotted the Fibonacci retracement levels by clicking on the Swing Low at .6955 on April 20 and dragging the cursor to the Swing High at .8264 on June 3. Tada! The software magically shows you the retracement levels. As you can see from the chart, the Fibonacci retracement levels were .7955 (23.6%), .7764 (38.2%), .7609 (50.0%), .7454 (61.8%), and .7263 (76.4%). Now, the expectation is that if AUD/USD retraces from the recent high, it will find support at one of those Fibonacci retracement levels because traders will be placing buy orders at these levels as price pulls back. Now, let’s look at what happened after the Swing High occurred.

Price pulled back right through the 23.6% level and continued to shoot down over the next couple of weeks. It even tested the 38.2% level but was unable to close below it. Later on, around July 14, the market resumed its upward move and eventually broke through the swing high. Clearly, buying at the 38.2% Fibonacci level would have been a profitable long term trade! Downtrend Now, let’s see how we would use the Fibonacci retracement tool during a downtrend. Below is a 4-hour chart of EUR/USD.

As you can see, we found our Swing High at 1.4195 on January 25 and our Swing Low at 1.3854 a few days later on February 1. The retracement levels are 1.3933 (23.6%), 1.3983 (38.2%), 1.4023 (50.0%), 1.4064 (61.8%) and 1.4114 (76.4%). The expectation for a downtrend is that if price retraces from this low, it could possibly encounter resistance at one of the Fibonacci levels because traders who want to play the downtrend at better prices may be ready with sell orders there. Let’s take a look at what happened next.

Yowza, isn’t that a thing of beauty?! The market did try to rally, stalled below the 38.2% level for a bit before testing the 50.0% level. If you had some orders either at the 38.2% or 50.0% levels, you would’ve made some mad pips on that trade. In these two examples, we see that price found some temporary forex support or resistance at Fibonacci retracement levels. Because of all the people who use the Fibonacci tool, those levels become self-fulfilling support and resistance levels. One thing you should take note of is that price won’t always bounce from these levels. They should be looked at as areas of interest, or as Cyclopip likes to call them, “KILL ZONES!” We’ll teach you more about that later on. For now, there’s something you should always remember about using the Fibonacci tool and it’s that they are not always simple to use! If they were that simple, traders would always place their orders at Fibonacci retracement levels and the markets would trend forever. In the next lesson, we’ll show you what can happen when Fibonacci retracement levels fail.

How to Use RSI (Relative Strength Index)

Relative Strength Index, or RSI, is similar to the stochastic in that it identifies overbought and oversold conditions in the market. It is also scaled from 0 to 100. Typically, readings below 30 indicate oversold, while readings over 70 indicate overbought.

How to Trade Using RSI

RSI can be used just like the stochastic. We can use it to pick potential tops and bottoms depending on whether the market is overbought or oversold.

Below is a 4-hour chart of EUR/USD.

EUR/USD had been dropping the week, falling about 400 pips over the course of two weeks.

On June 7, it was already trading below the 1.2000 handle. However, RSI dropped below 30, signalling that there might be no more sellers left in the market and that the move could be over. Price then reversed and headed back up over the next couple of weeks.

Determining the Trend using RSI

RSI is a very popular tool because it can also be used to confirm trend formations. If you think a trend is forming, take a quick look at the RSI and look at whether it is above or below 50.

If you are looking at a possible uptrend, then make sure the RSI is above 50. If you are looking at a possible downtrend, then make sure the RSI is below 50.

In the beginning of the chart above, we can see that a possible downtrend was forming. To avoid fake outs, we can wait for RSI to cross below 50 to confirm our trend. Sure enough, as RSI passes below 50, it is a good confirmation that a downtrend has actually formed.

How to Use Stochastic

The Stochastic is another indicator that helps us determine where a trend might be ending.

By definition, a Stochastic is an oscillator that measures overbought and oversold conditions in the market. The 2 lines are similar to the MACD lines in the sense that one line is faster than the other.

How to Trade Using the Stochastic

As we said earlier, the Stochastic tells us when the market is overbought or oversold. The Stochastic is scaled from 0 to 100.

When the Stochastic lines are above 80 (the red dotted line in the chart above), then it means the market is overbought. When the Stochastic lines are below 20 (the blue dotted line), then it means that the market is oversold.

As a rule of thumb, we buy when the market is oversold, and we sell when the market is overbought.

Looking at the chart above, you can see that the Stochastic has been showing overbought conditions for quite some time. Based on this information, can you guess where the price might go?

If you said the price would drop, then you are absolutely correct! Because the market was overbought for such a long period of time, a reversal was bound to happen.

That is the basics of the Stochastic. Many traders use the Stochastic in different ways, but the main purpose of the indicator is to show us where the market conditions could be overbought or oversold.

Over time, you will learn to use the Stochastic to fit your own personal trading style.

How to Use Parabolic SAR

Up until now, we’ve looked at indicators that mainly focus on catching the beginning of new trends. Although it is important to be able to identify new trends, it is equally important to be able to identify where a trend ends. After all, what good is a well-timed entry without a well-timed exit?

One indicator that can help us determine where a trend might be ending is the Parabolic SAR (Stop And Reversal). A Parabolic SAR places dots, or points, on a chart that indicate potential reversals in price movement.

From the image above, you can see that the dots shift from being below the candles during the uptrend to above the candles when the trend reverses into a downtrend.

How to Trade Using Parabolic SAR

The nice thing about the Parabolic SAR is that it is really simple to use. We mean REALLY simple.

Basically, when the dots are below the candles, it is a buy signal.

When the dots are above the candles, it is a sell signal.

Simple?

Yes, we thought so.

This is probably the easiest indicator to interpret because it assumes that the price is either going up or down. With that said, this tool is best used in markets that are trending, and that have long rallies and downturns.

You DON’T want to use this tool in a choppy market where the price movement is sideways.

Using Parabolic SAR to exit trades

You can also use Parabolic SAR to help you determine whether you should close your trade or not.

Check out how the Parabolic SAR worked as an exit signal in EUR/USD’s daily chart above.

When EUR/USD started sliding down in late April, it seemed like it would just keep droppin’ like it’s hot. A trader who was able to short this pair has probably wondered how low it can go.

In early June, three dots formed at the bottom of the price, suggesting that the downtrend was over and that it was time to exit those shorts.

If you stubbornly decided to hold on to that trade thinking that EUR/USD would resume its drop, you would’ve probably erased all those winnings since the pair eventually climbed back near 1.3500.

How to Use the MACD Indicator

MACD is an acronym for Moving Average Convergence Divergence. This tool is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish. After all, our top priority in trading is being able to find a trend, because that is where the most money is made.

With an MACD chart, you will usually see three numbers that are used for its settings.

• The first is the number of periods that is used to calculate the faster moving average.
• The second is the number of periods that is used in the slower moving average.
• And the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.

For example, if you were to see “12, 26, 9″ as the MACD parameters (which is usually the default setting for most charting packages), this is how you would interpret it:

• The 12 represents the previous 12 bars of the faster moving average.
• The 26 represents the previous 26 bars of the slower moving average.
• The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram (the green lines in the chart above).

There is a common misconception when it comes to the lines of the MACD. The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.

In our example above, the faster moving average is the moving average of the difference between the 12 and 26-period moving averages. The slower moving average plots the average of the previous MACD line. Once again, from our example above, this would be a 9-period moving average.

This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average. This smoothens out the original line even more, which gives us a more accurate line.

The histogram simply plots the difference between the fast and slow moving average. If you look at our original chart, you can see that, as the two moving averages separate, the histogram gets bigger.

This is called divergence because the faster moving average is “diverging” or moving away from the slower moving average.

As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is “converging” or getting closer to the slower moving average.

And that, my friend, is how you get the name, Moving Average Convergence Divergence! Whew, we need to crack our knuckles after that one!

Ok, so now you know what MACD does. Now we’ll show you what MACD can do for YOU.

How to Trade Using MACD

Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one.

When a new trend occurs, the fast line will react first and eventually cross the slower line. When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed.

From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend. Notice that when the lines crossed, the histogram temporarily disappears.

This is because the difference between the lines at the time of the cross is 0. As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is good indication of a strong trend.

Let’s take a look at an example.

In EUR/USD’s 1-hour chart above, the fast line crossed above the slow line while the histogram disappeared. This suggested that the brief downtrend would eventually reverse.

From then, EUR/USD began shooting up as it started a new uptrend. Imagine if you went long after the crossover, you would’ve gained almost 200 pips!

There is one drawback to MACD. Naturally, moving averages tend to lag behind price. After all, it’s just an average of historical prices.

Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag. However, MACD is still one of the most favored tools by many traders.

How to Use Bollinger Bands

Let’s compare trading to building a house. You wouldn’t use a hammer on a screw, right? Nor would you use a buzz saw to drive in nails. There’s a proper tool for each situation.

Just like in trading, some trading tools and indicators are best used in particular environments or situations. So, the more tools you have, the better you can adapt to the ever-changing market environment.

Or if you want to focus on a few specific trading environments or tools, that’s cool too. It’s good to have a specialist when installing your electricity or plumbing in a house, just like it’s cool to be a Bollinger Band or Moving Average expert.

There are a million different ways to grab some pips!

For this lesson, as you learn about these indicators, think of each as a new tool that you can add to that toolbox of yours.

You might not necessarily use all of these tools, but it’s always nice to have plenty of options, right? You might even find one that you understand and comfortable enough to master on its own. Now, enough about tools already!

Let’s get started!

Bollinger Bands

Bollinger Bands, a chart indicator developed by John Bollinger, are used to measure a market’s volatility.

Basically, this little tool tells us whether the market is quiet or whether the market is LOUD! When the market is quiet, the bands contract and when the market is LOUD, the bands expand.

Notice on the chart below that when price is quiet, the bands are close together. When price moves up, the bands spread apart.

That’s all there is to it. Yes, we could go on and bore you by going into the history of the Bollinger Band, how it is calculated, the mathematical formulas behind it, and so on and so forth, but we really didn’t feel like typing it all out.

In all honesty, you don’t need to know any of that junk. We think it’s more important that we show you some ways you can apply the Bollinger Bands to your trading.

Note: If you really want to learn about the calculations of a Bollinger Band, then you can go to www.bollingerbands.com.

The Bollinger Bounce

One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. That is the whole idea behind the Bollinger bounce. By looking at the chart below, can you tell us where the price might go next?

If you said down, then you are correct! As you can see, the price settled back down towards the middle area of the bands.

What you just saw was a classic Bollinger Bounce. The reason these bounces occur is because Bollinger bands act like dynamic support and resistance levels.

The longer the time frame you are in, the stronger these bands tend to be. Many traders have developed systems that thrive on these bounces and this strategy is best used when the market is ranging and there is no clear trend.

Now let’s look at a way to use Bollinger Bands when the market does trend.

Bollinger Squeeze

The Bollinger Squeeze is pretty self-explanatory. When the bands squeeze together, it usually means that a breakout is getting ready to happen.

If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break out below the lower band, then price will usually continue to go down.

Looking at the chart above, you can see the bands squeezing together. The price has just started to break out of the top band. Based on this information, where do you think the price will go?

If you said up, you are correct again!

This is how a typical Bollinger Squeeze works.

This strategy is designed for you to catch a move as early as possible. Setups like these don’t occur every day, but you can probably spot them a few times a week if you are looking at a 15-minute chart.

There are many other things you can do with Bollinger Bands, but these are the 2 most common strategies associated with them. It’s time to put this in your trader’s toolbox before we move on to the next indicator.

Summary: Japanese Candlesticks

• If the close is above the open, then a hollow candlestick (usually displayed as white) is drawn.
• If the close is below the open, then a filled candlestick (usually displayed as black) is drawn.
• The hollow or filled section of the candlestick is called the “real body” or body.
• The thin lines poking above and below the body display the high/low range and are called shadows.
• The top of the upper shadow is the “high”.
• The bottom of the lower shadow is the “low”.

Long bodies indicate strong buying or selling. The longer the body is, the more intense the buying or selling pressure.

Short bodies imply very little buying or selling activity. In street forex lingo, bulls mean buyers and bears mean sellers.

Upper shadows signify the session high.

Lower shadows signify the session low.

There are many types of Japanese candlestick patterns, but they can be categorized into how many bars make up the candlestick pattern. There are single, dual, and triple candlestick formations. The most common types of Japanese candlestick patterns are the following:

Just refer to the Japanese Candlesticks Cheat Sheet for a quick reference on what these candlestick patterns mean.

Combine candlestick analysis with support and resistance levels for best results.

And finally, here are some words of wisdom.

Just because candlesticks hint at a reversal or continuation, it doesn’t mean it will happen for sure! You must always consider market conditions and what price action is telling you.

This is the forex market and nothing is set in stone!

Japanese Candlestick Cheat Sheet

Did you click here first? If you did, stop reading right now and go through the entire Japanese Candlesticks Lesson first!

If you’re REALLY done with those, here’s quick one page reference cheat sheet for single, dual, and triple Japanese candlestick formations to easily identify what kind of pattern you are looking at whenever you are trading.

Go ahead and bookmark this page… No need to be shy!

Triple Candlestick Patterns

Evening and Morning Stars

The morning star and the evening star are triple candlestick patterns that you can usually find at the end of a trend. They are reversal patterns that can be recognized through these three characteristics:

1. The first candlestick is a bullish candle, which is part of a recent uptrend.
2. The second candle has a small body, indicating that there could be some indecision in the market. This candle can be either bullish or bearish.
3. The third candlestick acts as a confirmation that a reversal is in place, as the candle closes beyond the midpoint of the first candle.

Three White Soldiers and Black Crows

The three white soldiers pattern is formed when three long bullish candles follow a downtrend, signaling a reversal has occurred. This type of triple candlestick pattern is considered as one of the most potent in-yo-face bullish signals, especially when it occurs after an extended downtrend and a short period of consolidation.

The first of the three soldiers is called the reversal candle. It either ends the downtrend or implies that the period of consolidation that followed the downtrend is over.

For the pattern to be considered valid, the second candlestick should be bigger than the previous candle’s body. Also, the second candlestick should close near its high, leaving a small or non-existent upper wick.

For the three white soldiers pattern to be completed, the last candlestick should be at least the same size as the second candle and have a small or no shadow.

The three black crows candlestick pattern is just the opposite of the three white soldiers. It is formed when three bearish candles follow a strong uptrend, indicating that a reversal is in the works.

The second candle’s body should be bigger than the first candle and should close at or very near its low. Finally, the third candle should be the same size or larger than the second candle’s body with a very short or no lower shadow.

Three Inside Up and Down

The three inside up candlestick formation is a trend-reversal pattern that is found at the bottom of a downtrend. This tripe candlestick pattern indicates that the downtrend is possibly over and that a new uptrend has started. For a valid three inside up candlestick formation, look for these properties:

1. The first candle should be found at the bottom of a downtrend and is characterized by a long bearish candlestick.
2. The second candle should at least make it up all the way up to the midpoint of the first candle.
3. The third candlestick needs to close above the first candle’s high to confirm that buyers have overpowered the strength of the downtrend.

Conversely, the three inside down candlestick formation is found at the top of an uptrend. It means that the uptrend is possibly over and that a new downtrend has started. A three inside down candlestick formation needs have the following characteristics:

1. The first candle should be found at the top of an uptrend and is characterized by a long bullish candlestick.
2. The second candle should make it up all the way down the midpoint of the first candle.
3. The third candlestick needs to close below the first candle’s low to confirm that sellers have overpowered the strength of the uptrend.