By: Huzefa Hamid
So far in this mini-series, we have constructed the Fibonacci percentages and we’ve looked at price retracements and extensions hitting Fibonacci levels. Last week, we looked specifically at the 88.6% retracement level and how it could be traded.
This week, we’re going to look at an example using a Fibonacci level as part of larger chart pattern.
In last week’s GBP/USD example, the 88.6% Fib retracement level was the reason for the trade and a smaller chart pattern (a triangle pattern) helped to pin the entry. In this week’s examples, the chart pattern itself is the reason for the trade and the Fib level helps to find the entry point.
The following chart shows the US Dollar versus Japanese Yen, USD/JPY, forming a bullish “Head & Shoulders” pattern. Here is a simplified diagram of this chart pattern:
So the pattern consists of three lows: the middle one larger than the two either side of it. The middle peak is therefore referred to as the head, and the left peak is the Left Shoulder and the right peak is the Right Shoulder. Connecting them is a “Neckline”.
In reality chart patterns do not come so neatly formed but over time you can train your eyes to spot them. This is what I saw as a Head & Shoulders pattern forming on the following USD/JPY 15-minute chart:
The two blue circles highlight the Left Shoulder and Head, and the red line is the neckline. At the time I was looking at the chart, the pattern wasn’t complete and there was a potential Right Shoulder forming. It’s important to emphasise that the Right Shoulder was still potentially forming: the price could continue moving down and not complete the pattern.
I don’t see or trade this pattern often, but I liked it in this case because (a) I felt the neckline was very clear with multiple touches and (b) I had identified quite clearly the Left Shoulder and Head. Classical technical analysis teaches that a trader should enter when the Neckline is broken or when the Neckline is re-tested after it is broken (i.e. when it is broken but the price comes back down to touch it as support). However, I prefer to enter the pattern before the Neckline is broken. This is because if the price breaks the Neckline, it can still be a false breakout and come back to hit your stop-loss. If instead, you enter during the formation of the Right Shoulder, the price can break the neckline but just come back to your entry leaving you room to exit at breakeven rather than take a loss.
Zooming into a 5-minute chart, I noticed the price bounced against the 88.6% Fib level between the Low Point-1 and the High Point-2:
(The blue circle is the Head of the Head & Shoulders pattern.) I’ve marked my entry with the small red line. My reasoning was that the price would at the very least go back up to Point-2 and this would allow me to move my stop-loss to breakeven. Of course, the price could continue down after my entry and give me a loss near my initial stop-loss at Point-1. But the risk would be small compared to entering at the neckline and keeping a larger stop-loss.
Let’s see how the trade unfolded:
I’ve now marked the full chart pattern with the Neckline, and the three circles highlighting the Left Shoulder, Head and Right Shoulder. My entry is marked with the small red line. The price successfully broke the Neckline after touching it a couple more times and then hovering around it. My early entry identified with an 88.6% Fib retracement allowed me a much tighter stop-loss of 15 pips. I took profits at 60 pips (after the first long bar up): once the price spiked up very quickly, I was weary of a retracement plus I had covered four times my initial risk, or a 1:4 risk/reward ratio.
1. When you’re looking at a chart pattern you would like to trade from, a Fib level can help identify an entry.
2. Using Fib levels can often allow you to enter earlier than if you used the chart pattern by itself.
3. Earlier entries, particularly on smaller time-frames give smaller stop-losses and better risk-reward trades.
Want to learn more? Check out the rest of this Fibonacci and Forex miniseries!