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Why I Like the 61.8% Fibonacci Retracement Setup

As most traders know, trading becomes a lot easier when positions can be opened semi-automatically based on a template trading setup. One of my favorites, especially regarding currency pairs such as EUR/USD, is a setup based on 61.8% Fibonacci retracement including extension. A retracement is a move in the opposite direction of the prior move. An extension is the length of the continuation of the prior move after a retracement is completed.

Please beware: the following chart analysis is obviously ‘behind-the-fact’, but it may offer an useful insight what price action might follow when certain key retracement levels are hit. Let’s take a look on the upward move starting July 21 (see figure 1). A strong move of more than 1.5 cent or 160 pips is followed by a significant retracement of exactly 100 pips. We can see that this is only 0.5pip more than a 61.8% retracement. 61.8% is a key number in the Fibonacci sequence and is regarded as the most important level in retracements. Looking at the larger swings in the chart, we can identify 3 strong 61.8% retracements (see numbers in chart). There’s another a 61.8% retracement which is briefly broken (see orange arrow), so we may count 4 times. Two other swings, the upward-move from July 24-27 and the down-move July 31 to august 5 show perfect 38.2% hits for a potential retrace (see blue arrows), but these hits are soon followed by a deeper retracement.

Fibonacci retracements click on image to enlarge

Now the big question is: how should we trade these 61.8% retracements? I don’t trade the retracement itself, since one has to call both top (start of retracement) and bottom (end of retracement). When prices are retracing, it is often difficult to tell how far the retracement goes. What’s more, you want to have a confirmation that prices are indeed moving the opposite direction. As a consequence, a large chunk of the opportunity is already over when a retracement is obvious enough to trade. So it’s safer to wait until retracement levels are hit and a continuation of the prior move is likely to start. Personally, I look for exact hits (+/- 2 pips) of the 61.8% retracement level, followed by a candle in the opposite (prior move) direction. Sometimes I take M5 candles, sometimes a couple of M1 candles to verify whether it’s a perfect hit or not and prices are moving the same direction as the prior move.

But recognizing the retracement is just a starting point. We have to make an estimation where prices could move and make a trade plan with a reasonable risk/reward proposition. Let’s take a closer look at the first retracement from figure 1, labeled 1. During the retracement, we draw our Fibonacci lines and wait for the 61.8% to get hit. Meanwhile, we are considering a potential stop loss (SL) in case we see a viable entry at the 61.8% retracement. A new low (beyond the start of the prior move) might be an option, though this would mean a 70 pips move, potentially more since entry will be at a level worse than the hit at 61.8%. In such cases, I draw the next Fibonacci level, in this case 76.4% (or 78.6%, depends of which Fibonacci-school one is) and look if that’s an interesting point in the graph. That certainly looks the case here, see the arrow at a small low during the late morning of July 21. So let’s place a potential stop loss level close but below that level: 1.0835.

click on image to enlarge

What could be a proper level to take profit? According to various literature, for instance “Elliot Wave Principle” by Frost & Prechter, retracements are followed by Fibonacci extensions. Popular extensions are 61.8% of the prior move, 100%, 161.8% etc. Since we are trading a swing on a relatively short timeframe, probably lasting one or two days, larger extensions are out of scope (but not ruled out!). I prefer to look at the 100% extension and relate that to the number of pips. If 100% is more than 100 pips away, I’m more conservative and might set a lower target as long as risk/reward is more than 1:2. With a SL close to 76.4%/78.6% and a target of at least 61.8% extension, this condition is always met. Consider the formula:

TP > SL = 0.618*0.618 > (78.6%-61.8%)*2

Calculated in pips, here we have a SL of 35 pips but let’s say we are slow with our entry (waiting for a next M5 candle higher) so that we enter 5-10 pips from the 61.8% retracement level. SL will be 40-45 pips. A take profit can be set at 80-90 pips from retracement. This is indeed below the 61.8% extension. So a minimum Risk/Reward of 1:2 is possible. But let’s zoom in at the actual entry.

The M5 graph shows that the candle following immediately after the 61.8% hit (low at 1.0869 so only 0.5 pip off target!), moves again in the direction of the prior move. Fans of candlestick patterns will recognize a ‘hammer’, which supports our case for an entry. A relatively easy entrance within a range of 5-10 pips of the retracement hit was possible.

click on image to enlarge

Price developed according to set-up and a take profit with risk/reward of 1:2 was achievable. More interesting however was the precise hit of the 161.8% extension 3 trading days later. However this included a weekend in between and was a 250+ pips move in total. Question is whether a trader is able to keep the position open to this point. In addition, looking at figure 2, a second 61.8% retracement occurred during this period. After this retracement however, 161.8% extension was too optimistic. Please see figure 4 for extensions. In all four occasions, extensions reached over 100% and in 3 cases even the 161.8% extension level was hit.

click on image to enlarge

Concluding, the 61.8% retracement offered a couple of nice opportunities in EURUSD trading. We can’t trade in the past, so don’t take succesful outcome for granted when trading this setup. When a 61.8% retracement is hit, it doesn’t mean that it’s an easy trade. The examples shown in this article are ideal situations in a relatively short period of time. Trades don’t unfold always according to this setup. Sometimes a trade requires active management, for instance moving stop losses to protect profit after a key extension level is hit. However, keep attention to this retracement level, I’m sure comparable trading set ups will arise. Using extension levels to determine take profit levels may offer excellent risk/reward trades.

This trading style is off course not only for trading in EURUSD but also applicable for other currencies and assets, see for instance my previous article on AUDUSD (click here). For the larger part the story above describes what my favorite trading setup is. This kind of trading setup is easy to identify and execute, although it sometimes takes a while before these opportunities arise.