Trend Based Fibonacci Trading

Trend Based Fibonacci Trading

This chapter and the following two chapters outlining grouping and trading techniques are where the meat of the useful nature of this material will be presented. So far, all the previous material was presented to enable you to: recreate on your own the following techniques; and experiment with them to suit your own trading needs. Be proud. You’ve wallowed through all the background mathematics and now are ready to see what can be done with it.

As discussed earlier, the main reason behind determining the Fibonacci areas is to establish places we think might act as support or resistance. Once an area is determined, a decision must be made on the technique to be used to implement a trade (based on the assumption that the area is a valid support or resistance area). Now think about this simple but often overlooked idea. If an area of support or resistance ‘holds’, the price won’t go through the area. It will act as a barrier, but it may or may not reverse the price.

When trading, the usual assumption, if one is using areas of support or resistance, is that the price action will reverse off the area. The trade makes money because you are now involved with a new trend. The price may just stop and then go sideways, but you are playing for the trend to change in the area you are looking at. What you are doing is betting on a reversal. You are picking a top or a bottom.

Now wait, I thought the trend was your friend, and that you never want to try to pick tops and bottoms. Well, I think that’s generally true. But as I examined many charts of the trades I was doing, I found that the techniques that I used were just about always attempting to pick tops and bottoms. Before you get too confused, let me explain.

For any given chart you will see uptrends, downtrends and sideways periods. But notice an uptrend, for example, how it has small pullbacks as it goes up (recall ‘trees don’t grow to the sky’, from Internal Retracement?). Well, on a smaller timeframe these pullbacks are actually downtrends. So you are down trending at that moment within a larger degree uptrend. You can play that word game over and over by looking at multiple smaller and larger timeframes, finding a near infinite number of uptrends and downtrends on the same chart. See figure 8.1.

Here MMM is in a strong uptrend on the daily chart. There are multiple pullbacks where one might attempt to enter a trade in the direction of this strong uptrend. Let’s look at the pullback that starts October 29, on a 15- minute chart. See figure 8.2.

This pullback is a clear downtrend on the 15-minute timeframe, in the context of a larger degree uptrend on the daily timeframe.

Now, here’s the point. Say you want to stay with the trend, so you find a timeframe that you want to trade, and find an uptrend you want to get on board. You decide that you will enter on a pullback (a very common and highly used technique). You are all about the trend, not fighting the established line of motion, since you know picking tops and bottoms is exceedingly difficult, right?

Do you see the problem, though? Dial your chart down to a lower timeframe and look at just the pullback. See figure 8.4. 

I hope you see what you’ve just done. You’ve tried to pick the bottom, in this case, of what looks like a clear downtrend. Now wait, this is exactly what we just said we were not going to do. In my opinion, this is the trader’s dilemma.

Unless you want to just buy into a rising market, or sell a falling market and hope it keeps going, you will be faced with this dilemma. I find it very interesting that there are many, many references out there that tell you how important it is to go with the trend, and yet very few will point out what we are looking at right now. So, what do we do?

I think the first thing we should take note of is the importance of a given trend. The higher the timeframe the trend is in, the more important that trend generally is. The idea is that a trend in motion will stay in motion until something acts to change that. So, a trend on the daily has more ‘momentum’ than a trend on a 5-minute chart, all other factors being equal.

For this reason, I generally follow the common practice of looking at three-time frames when I trade. First, I determine the traded timeframe; the timeframe that shows a trend I want to trade. Then I choose a higher timeframe, usually three to five times as high. I use this timeframe for context, to see if what I think is a nice trend might actually be a pullback within a larger trend. Lastly, I determine a ‘trigger’ timeframe; again, usually three to five times lesser than the traded timeframe.

Let’s say I see this downtrend on the 5-minute chart. A pullback develops and I want to try a trade with this 5-minute trend. I look at the 15-minute chart to see what the larger scale picture is for this issue right now. See figure 8.6.

The last bar on this 15-minute chart encompasses the entire three bar pullback from the 5-minute chart in figure 8.5. The perspective is quite different with this additional information. It shows a much larger scale downtrend on the 15-minute chart.

At this point let’s not critique the merits of this trade, or evaluate things we may see on this 15-minute chart. Yes, we all see the possible near exhaustion move down at the end of the previous day that followed a larger than usual pullback, the gap down, the staleness of the trend, the sideways action developing, and so on. Let's Just use the chart right now to determine that the 15-minute chart trend is also down.

The trade, as seen in figure 8.8, is now triggered at this point.

Let’s see how this trade played out. Where you would have taken the trade-off would depend on your own trading style. If the trade was initiated off the 5-minute chart and triggered on the I-minute, those may also be good places to look for a plan to close the trade. See figure 8.9.

The pullback we have been looking at is the first pullback in the downtrend on this 5-minute chart (see arrow on figure 8.9). As you can see, there was ample opportunity to profit on this trade, and despite the reservations previously discussed, this one did start another leg down.

One of the main points I want to convey is that we will be looking for trades in the direction of the trend, and trying to find a point where a pullback may end. The 'traded timeframe' is determined by the trend that we want to trade. Pick a ’traded timeframe' that clearly shows the entire trend and the pullbacks. We will then go down to a lower time frame, and knowing full well that we are trying to pick a top or a bottom in this counter trend pullback, we will look for a trigger to do just that, in the context of the larger scale trend.

Sometimes it seems like the trend that we are following is getting old and has run a long way. This leads to the temptation to try to pick the end of the run, be it a top or a bottom (depending on if we are looking at an uptrend or downtrend). Using some of the Fibonacci calculations you can determine areas where the trend may end. I want to warn the reader, though; this is a very low-probability proposition.

I will, instead, suggest that you dial up to a larger time frame, and look to see if this trend may be a pullback within a larger trend. If so, calculate possible places for the pullback to end. These areas where the pullback may end may overlap the areas calculated for the traded timeframe trend itself to end. Now you have something similar to what we have been developing all along. You have simply gone up to trade a higher timeframe. This would likely be a higher probability trade. The idea is: don’t try to pick when the traded timeframe trend will end.