Investing 101: FX Fibonacci Retracements + Chart Patterns
Following on from previous articles, today’s article will cover some common patterns that can assist with your analysis in the FX markets. I typically use price action (covered here) followed by indicators as a confirmation tool. However, some traders use a combination of indicators, which forms the basis of their strategy without looking at general price action. I personally think of price action as superior because indicators lag behind price action itself. Therefore, indicators often give false positives. There are too many patterns out there to cover within the scope of this article, so I will only focus on a few I have used in the past and give some book recommendations which offer more comprehensive insights. There is also an upcoming article covering FX indicators so stay tuned.
The Fibonacci retracement tool allows for the detection of potential support and resistance zones. These are additional to zones identified from price action covered in the last article, but they often overlap. If you find that this is the case, then this adds more confirmation to your analysis. Remember, the confluence of many factors supporting your direction increases the likelihood of your analysis materialising as expected. The key Fibonacci levels are: 0.236, 0.382, 0.5, 0.618, and 0.786. To run Fibonacci, you should first identify the predominant market direction and the most recent swing low and swing high. A valid swing should make it to at least 50 per cent of its previous swing. It could be risky to buy/sell at any retracement less than that because it doesn’t reflect a healthy trending environment with identifiable highs and lows. If the market is bearish, you click on the swing high and drag the cursor to the most recent swing low. On the other hand, if the market is bullish, you click on the swing low and drag the cursor to the most recent swing high.
Tip: I found that the most important retracement levels are 0.618 and 0.786, although anywhere up to 1 is fine, as it is essentially the previous high/low and could signal a ranging environment. Unless it breaks above its previous high/low, we are still looking at previously identified market structures.
Let’s take a look at an example of GBP/CHF on a 4H timeframe. I identified the swing low and the swing high and then ran the Fibonacci retracement tool. As you can see the 0.5 level was predictive of the first bounce, which would be a great target to enter a trade. Then we can see the price went all the way up to its previous high, and back down again to the 0.5 level. Although, as Fibonacci levels often remain significant over longer periods of time, I recommend running a completely new analysis before each trade.
I recommend reading “Fibonacci Trading: How to Master the Time and Price,” by Carolyn Boroden, where all of this is covered more extensively. Boroden also covers Fibonacci extensions and price clusters, which are great for determining potential price projections. Of course, the levels won’t always work, but they do add confirmation to your set up.
The Gartley pattern can be identified using Fibonacci price ratios. Although its swing violates the previous high/low which often signals trend reversal, the Gartley pattern signals a correction of a directional move before it resumes. It looks like a slanted “M'' for a bearish continuation or a “W” for a bullish continuation. There are four Fibonacci based rules that must be met for the pattern to constitute a Gartley pattern (refer to the image below; source: babypips.com):
Move AB should be the 0.618 retracement of move XA.
Move BC should be either 0.382 or 0.886 of move AB.
If the retracement of move BC is 0.382 of move AB, then CD should be 1.272 of move BC. Consequently, if move BC is 0.886 of move AB, then CD should extend 1.618 of move BC.
Move CD should be the 0.786 retracement of move XA.
With this one, we’re going to cheat a little. The Gartley pattern is extremely difficult to spot with a naked eye, therefore, we can use harmonicpattern.com, as it does it for us. The software covers a whole range of other harmonic patterns which are essentially geometric shapes based on Fibonacci levels, so if you wish to explore, go for it. Below you can see that I activated the Gartley pattern button and the software identified it on a selected timeframe. It also provided the take profit, stop loss, and risk to reward ratio of the trade. If the trade plays out according to the pattern- boom!- you’ve got yourself a signal from an AI robot.
Head and Shoulder Pattern
This is personally one of my favourite chart patterns, it is easy to spot and if it occurs on a larger time frame you can secure many pips relatively quickly. As the name suggests, the pattern should look like a shoulder-head-shoulder and signals a collapse in price. On the other hand, an inverted head and shoulders signals an upward rally. For the purpose of this illustration, we’ll focus on the head and shoulder as a bearish pattern. To identify the pattern there are three criteria that must be met:
Left shoulder: An ascent in price and then a fall back to a certain support level known as the neckline.
Head: A further ascent in price, surpassing the high set by the left shoulder and descent back to the neckline.
Right shoulder: A final ascent in price, ideally not going as high as the head, and a final descent back to the neckline, which it breaks beneath on strong volume.
Take a look at the example of USD/CAD on a 4H chart. We see an upward rally that descends back to a support level (the neckline), a head formation that surpasses the left shoulder and retraces back to the previously established level, and a right shoulder that breaks through it. Note how the price retraced back to the neckline after breaking through it (support turns resistance). This doesn’t always happen but if your stop loss is placed a couple of pips above the neckline then you’d catch many pips even after the initial breakout. Your take profit point (TP) should be where the initial rally of the left shoulder began. Easy pips if you ask me!
Ascending and Descending Triangle
Ascending and descending triangles are relatively easy patterns to spot. Here, we will focus on a descending triangle as a bearish continuation, but the same principles apply to an ascending triangle in reverse. In a bearish market, a pattern making a series of lower highs and identical lows is said to be creating a descending triangle and signals a continuation of the trend. A minimum of two swing highs and two swing lows are required to form the descending triangle's trendlines. The target price is often equal to the entry price minus the vertical height between the two trend lines at the time of the breakdown.
Take a look at the 4H chart of EUR/AUD below. Within the structure, we can see two descending lower highs and two equal lower lows within a bearish market structure. Note that you could draw a descending trend line according to the previous peak, however, as you can see, you would’ve been faked out before the market went back up creating a lower high. Now, if you were to re-enter roughly at the long wick (exhaustion of buyers), you could trail your stop loss to where you see an indication of rally discontinuation. However, you could also decide to wait until the price breaks below the flat structure. In this example, the price did not reach its target as measured by the difference between the entry price and the vertical height between the two trend lines, as such an alternative strategy for exit would need to be established. I could’ve found a textbook example, however, I thought it was important to make a point that these patterns aren’t always perfect, and some leeway may be desirable if you want to be profitable.
The flag pattern is a continuation pattern, whether found in a bullish market structure or a bearish market structure. Two requirements must be met to constitute a flag pattern:
It must be preceded by a sharp directional move that constitutes the flagpole.
It should then be followed by a countertrend correction enclosed by two parallel trendlines.
Be aware that if the flag itself corrects to more than 50 per cent of the flagpole, then the pattern is invalidated. The awesome thing about the flag pattern is that it often signals a lengthy breakout, often equal to the initial flagpole length!
Let’s have a look at a daily EUR/JPY chart below. We can clearly see a healthy upward rally, followed by a corrective move ranging between two trendlines. You could’ve entered the trade when it bounced off the lower trendline, however, it could be that it was going to retrace back down again. In this case, you’d still score some pips with a trailing stop loss. Alternatively, another great entry point was when the price broke out of the pattern. Notice how I measured the length of the initial rally (the flagpole) and then moved it beyond the breakout to check for a potential target price. Setting all the retracements aside, the price has reached our TP. However, this is not always the case, and a trailing stop loss with this pattern is also a great way to secure profit. Do bear in mind that this is a daily chart, therefore, even the initial daily candle following the breakout would make you a lot of money.
Today I have covered three main chart patterns I use in my trading, but there are many more. I cannot recommend the book “High-Probability Trade Setups: A Chartist's Guide to Real-Time Trading,” by Timothy Knight, highly enough. It goes over a whole variety of chart patterns and discusses them in terms of herd psychology.
In the next article, I will go over a couple of indicators to assist you with the general price action analysis covered so far. In the meantime, it may be worthwhile for you to try identifying these patterns yourself on tradingview.com. I hope these articles help you get started on your Forex journey. If you have any comments, please leave them below!