admin on August 27th, 2008
Leonardo Fibonacci (1170-1250) was an Italian mathematician, considered by many to be the most talended of the Middle Ages. He popularized a number series, which would later be named after him, as a model of the rabbit population growth generation by generation, but it will later be discovered that these number can be applied to a variety of other situations, including forex trading.
A Little Bit of Maths
The series starts with the numbers 0 and 1, and the next are the sum of the last two: so, putting it all together, the series starts with the numbers 0, 1, 1, 2, 3, 5, 8, 13, 21, and so on.
The mathematical limit
lim(i->+inf) { Fib(i)/Fib(i+1) }
or, in simpler terms, the ratio of an arbitrarily big number in the Fibonacci series and its successor, is 0.618, while the limit
lim(i->+inf) { Fib(i)/Fib(i+2) }
or the ratio of a Fibonacci number and the one two places after it in the sequence, yields 0.382. Subtracting these two numbers gives 0.236, their average is 0.500, and their sum is 1.000. Finally, 1.000 - 0.236 = 0.764.
Fibonacci Applied to Forex: Retracement and Extension Levels
The numbers we just learned about — 0, 0.236, 0.382, 0.500, 0.618, 0.764 and 1.000 — are called the “Fibonacci retracement levels”. With calculations similar to those we made in the last section we could also obtain the ratios of 0, 0.382, 0.618, 1.000, 1.382 and 1.618, which are referred to as the “Fibonacci extension levels”.
Once you find the “highest high” quickly followed by a “lowest low” and using them as the extremes to plot the Fibonacci retracement or extension levels on your trading platform, these ratios represent the levels, relative to the highest high/lowest low range, at which the pair is more likely to find a support or resistance level, that is, levels at which the pair will revert its trend.
Advanced Techniques: Fibonacci Fan and Others
Retracement and extension levels are not the only application of these ratios to currency trading: in fact, there are many other tools relying on them. We won’t have time here to discuss all of them, but it’s still worth mentioning another commonly used tool: the Fibonacci fan, which uses the ratios to plot support/resistance levels, this time with the trend lines converging to a single point (hence the term “fan”).
What Makes Fibonacci Reliable
It has been speculated that, although Fibonacci ratios can be very useful while trading, their effectiveness comes from its very widespread use among investors, which ends up influencing the market and the investor themselves, rather than because it is effective per se.
Although we don’t have a definite answer to this matter, it’s still worth pointing out that influencing a market which involves movements worth several trillion dollars every day wouldn’t certainly be something easy to achieve.
One way or another, knowing how to use these tools, although not too easy at first, will really help you along in your trading experience.
admin on August 26th, 2008
Drawdown and risk/reward ratio are two parameters to always keep in mind when trading forex, as they indicate your risk factor for your open trades in a very precise and clear way.
Even if you feel very confident about your trading strategy, using one that results in a gain, say, 65% of the time, Murphy’s Law (which is not just a cute joke, as it can be mathematically proved) says that sooner or later you’ll incur in a losing streak. It’s important to keep these chances to a minimum by using a proper risk/reward ratio and, when a losing streak happens, to keep drawdown in serious consideration before you place your next trade.
Drawdown and Maximum Drawdown in Forex
Let’s say you lose a series of trades which bring your equity from an initial $10,000 to just $6,666.66. You lost 33 % of your account, but how much do you have to get back to where you started from, relative to your current account?
If you answered 33 %, you are wrong. The actual percentage you have to earn back is 50 %: in fact, $6,666.66 x 150% = $10,000, while $6,666.66 x 133 % = $8866.66. In other terms, you faced a 50-33 = 17% drawdown.
Let’s see what happens if you continuously lose 20 % and win 20 % of your account.
| Trade 1 |
$10,000 |
| Trade 2 |
$8,000 |
| Trade 3 |
$9,600 |
| Trade 4 |
$7,680 |
| Trade 5 |
$9,216 |
| Trade 6 |
$7,372.8 |
| Trade 7 |
$8,847.36 |
| Trade 8 |
$7,077.88 |
| Trade 9 |
$8,493.46 |
| Trade 10 |
$6,794.77 |
Do you see where it’s going? Due to drawdown, alternately winning and losing 20% (or any other percentage) of your account is not enough at the end of the day. This holds true even if you started with a winning trade — it would just take a bit longer.
As we hope you realized, recovering from a consistent loss, in forex like in any other form of investment, gets increasingly harder. This is why you need to try avoiding serious drawdown by using an adequate risk/reward ratio.
Risk/Reward Ratio in Forex
A risk/reward ratio is, like the term suggests, the ratio between the expected maximum loss and the maximum gain. The great thing about forex trading is that you can decide your r/r with absolute precision by placing appropriate stop losses and take profits.
For instance, if you place your stop loss at 20 PIPs and your take profit at 40 PIPs, your r/r is 1/2. Please note that some say “reward/risk” ratio, so in this case the r/r would be 2: always make sure of what others mean, unless it’s obvious from the context.
What is a good r/r ratio? If you understood what we just said about drawdown, you know that a ratio of 1 is not going to work in the long term! In fact, drawdown is precisely the reason why you should always enter trades with a stop loss tighter than your take profit.
As an example, if you use a risk/reward ratio of 1/2 and your strategy lets you win 50% of your trades, here is what your account will look like after alternately winning 20% and losing 10% of your account:
| Trade 1 |
$10,000 |
| Trade 2 |
$9,000 |
| Trade 3 |
$10,800 |
| Trade 4 |
$9,720 |
| Trade 5 |
$11,664 |
| Trade 6 |
$10,497.6 |
| Trade 7 |
$12,597.12 |
| Trade 8 |
$11,337.41 |
| Trade 9 |
$13,604.89 |
| Trade 10 |
$12,244.40 |
Of course, entering in trades at random won’t give you a 50% chance of winning, because the profit target is more distant than the stop loss (and don’t forget you have to factor in the spread, too): however, with the help of tools from technical analysis and a bit of experience, coming up with a strategy to earn this figure is certainly feasible.
