Fibonacci and Trade Scaling

[RichardCox 10]

Fibonacci and Trade Scaling

 

When I first started trading I was losing in most of my positions – as everyone does. I started trading with no real strategy and whatever activity I was conducting should be described more as gambling than as trading. This is because there was no real ‘rhyme or reason’ to my approach and since I was randomly selecting assets to buy or sell, I had no better chance than guessing a coin flip on any given occasion. Of course, many lessons followed and a good deal of those had to do with the technical analysis techniques I have written about in the Forex column of this website.

 

But not everything comes down to mathematical probabilities, and there is a good deal of ‘common sense’ that is employed by every successful trader. One example of this can be seen in the fact that it is essentially impossible to consistently nail down the perfect trade entry. It is possible to get lucky now and then – even a stopped clock is right twice a day. But expecting to do this with any consistency is totally unrealistic and should not even be viewed as an approachable goal. Does this mean that traders should feel hopeless when making the decision to pull the trigger on a trade? Not at all.

 

Separating Your Trade Entries

 

The first mistake that many traders make is to place an entire position stake in a single location. For example, you are bullish on the Euro and you decide to buy the EUR/USD at 1.35. At best, these novice traders will at least follow the conventional wisdom and never enter into a position that puts more than 2% of your total account at risk. But this is not nearly enough trade planning as it still suggests that the trader had entered into the position at the exact right time and place. Since this is almost never the case, more work needs to be done in the planning stages – before any orders are executed.

 

Specifically, this means separating your positions into multiple parts. “The easiest way to scale into positions if doing to divide your trade size in twos or threes,” said Tony Davis, head trader at Atlanta Gold and Coin. “and then to find two or three places on your chart where price activity is likely to work in your favor (i.e. clearly defined support or resistance levels).”

 

Risks

 

I first realized that this was a preferable approach during a GBP/JPY trade, which as you might know is one of the more volatile forex pairs. At this stage, I was mostly looking for trades that risked about 125-150 pips but I quickly learned that this was an unrealistic expectation for this low-liquidity pair, which is capable of significant intraday moves. In this case, I quickly found my position in negative territory, down -150 pips, and I had to make a decision because I was starting to exceed my previous risk threshold. Some traders argue that you should never deviate from your original game plan, but I could never totally agree with that. Instead, I chose to double my position, and improve on my average price. In this case, the trade did rebound in my favor and I was able to close out at a profit.

 

Some experienced traders would argue that the above approach was a bad idea – and in some ways they are correct. I did break my original trading rules and expose myself to double the losses in a market that was already working against me. But I think the most valuable lesson for me in this case was that establishing your entire position in the same location (the same price level), is one of the biggest mistakes that a trader can make. Does that mean I should have doubled my position in the above scenario? No. It means that I should have divided my position in half (or in thirds, fourths, etc), and then scaled into the position once the market started working against me.

 

Of course, this means that your regular trading activities are going to become much more complicated. You cannot simply find a support or resistance level and then place your entire order in that area. Instead, you will need to find two or three (or more) separate entries and actively expect that the market is going to start working against you. Could the market immediately turn in your favor? Of course, and in this case you would not be trading at a full position size (which also means reduced profits). But what is most important here is to adequately manage risk and protect yourself from unnecessary losses. This benefit outweighs even the more substantial profits that would have been realized if you had staked your entire position and the market immediately started to work in your favor. The reason for this comes from the fact that the favorable scenario is far less likely, and will happen much less often when compared to situations where your initial trade entry was ‘less than perfect.’

 

Possible Strategies

 

 

(Chart Source: Orbex)

 

The next question you should be asking yourself here is: How can I find multiple entry points for a single trade? There are many ways of doing this. Even the simplest technical analysis strategies will generally outline more than one support or resistance level on any given chart, and these can be used to define price areas that that agree with your original strategy. For example, in the chart above, we can see relatively clear historical resistance levels in the Euro at 1.37 and just above 1.38. Many charts will have more than two support or resistance lines drawn. So hypothetically, there would be nothing wrong with establishing half a short position once prices reach 1.37 and then wait to add on the second half if prices continue higher into the 1.38s.

 

This would give you an average position size of roughly 1.3760, rather than your original 1.37. When you have live positions, this added trade cushioning can make a significant difference if things start to work out unfavorably. But what is even more important here is the fact that prices would have had to break all of your original prices and the next one in order to stop you out. Moves like this are relatively unlikely, and these types of market tendencies are outlined in these courses to learn finance online. This is one way that traders can turn the probabilities in their own favor, and this is a strategy approach that should be applied in almost all cases.

 

Fibonacci

Fibonacci studies offer another possibility. But what is most important to remember with Fibonacci is that the numbers should be viewed as approximations. Many traders claim to base positions on the ‘cosmic nature’ of the Fibonacci sequence (the Golden Ratio). The financial markets are just another organism in the universe, why wouldn't they follow the rules of physics that every other entity must follow (tree branches, shell shapes, hurricanes, etc.). Not all of us subscribe to these types of ideas and not all us us feel the need to define a retracement by its relationship to the 38.2% or 61.8% Fib level.

 

Instead, I am interested in what is happening to the price at any given moment. Is something likely to happen in this asset? Right now? If not, move on to the next chart. If so, start looking at how a trade could be positioned. It is just as acceptable to view these retracements in thirds, so instead of the 38.2% retracement, you are viewing the market as having had a one-third retracement of its original move.

 

Let’s say your criteria are met. In order to use Fibonacci, you need to identify a predetermined price move. This is easier said than done because there are a lot of prices moves on a price chart. Everything that happens on a price chart is a price move.

 

Fibonacci Example

 

Not enough space here to get into how to define a retracement move. I have explained Fibonacci in depth here in other articles (for example, here and here). The graphic below shows how you should be looking at when using Fibonacci to scale into a position.

 

 

(Chart Source: Orbex)

 

In the chart above, we can see clearly defined Fib resistance at 1.3770 (38.2% retracement), at 1.3820 ( the 50% retracement), and at 1.3860 (the 61.8% retracement). Traders looking to enter into bearish positions could place one short entry at each of these levels (a third in each position), with a stop above the two-thirds retracement of the original decline. This would allow you to scale into your position and protect against major upside risk while using the Fibonacci retracement.

[MidKnight 11]

I somewhat agree and disagree with your article. While I have made heavy use of scaling-in for my Hang Seng trading in the past, I do it very rarely nowadays for the following reasons:

 

• the practice shifts the methodology focus from being right rather than towards expectancy
  
• ego can become covertly intertwined with ones trade ideas because the focus is on being right
  
• as mentioned, if it only fills partial size and goes to targets you only get small profits. This is a big problem for a couple of reasons. First, one needs to track which happens more often. If it is quite common to fill your first entry and then go to target this will really hurt your bottom line. Secondly, it covertly teases the mind to want to be filled on your subsequent entries so you are at full size for a good pay day. This can be a huge risk to your trading mentality.
  
• to me, it isn't really following the market. The entries are out of blind faith.
  

 

Yes doing a scale-in approach can give an extremely nice win%, but in my personal trading it produces less money than a much lower win% method. Readers need to do the work and assess it for themselves within their own method.

 

With kind regards,

MK

[eliotchang 0]

eventually very basic but extremely useful tool