In a trending market, prices would still generally oscillate up and down. There would still be rallies and drops that would form swing highs and swing lows. However, there is a general pattern and a sense of direction between these rallies and drops.
Uptrends would generally form higher and higher swing highs and swing lows, while downtrends would also generally form lower swing lows and swing highs. Seasoned trend continuation traders would usually trade on pullbacks as the price oscillates in the direction of the trend. But how cheap is cheap, and what would be a good price level to enter a trade?
This strategy is a simple trading strategy that could help traders identify tradeable trending markets, as well as excellent pull-back zones where they could enter the market using the Supertrend indicator and the Fibonacci Retracement and Extension tools.
Supertrend Indicator
There are various ways traders identify trends and trend reversals. Some traders use price action on a naked chart, others use moving average lines, while others use some other type of trend following technical indicators.
One of the ways traders identify trends and trend reversals is with the use of the Average True Range (ATR). Many traders would identify reversals based on price action reversing against a prior trend direction by more than a preset multiple of the ATR. For example, a trader may consider a reversal from an uptrend to a downtrend if the price reverses against a prior swing high by more than three times the ATR.
The Supertrend indicator is a trend-following technical indicator based on the concept of using ATRs as a basis for trends and trend reversals. In an uptrend, it plots a green line below price action which is set at a distance coming from the most recent high which is a multiple of the ATR.
It also shades the area between the price and the green line pale green. Inversely, in a downtrend, it plots a red line above price action which is also based on a multiplier of the ATR coming from the most recent lows. It also shades the area between the price and the red line bisque.
The line shifts and changes color whenever the price closes on the opposite side of the line. These shifts and color changes are indications of a trend reversal.
Fibonacci Retracements and Extensions
The Fibonacci Retracement and Extension tools are built-in trading tools that can be found on the MT5 platform. These tools are based on the Fibonacci ratios.
The Fibonacci ratios are ratios of a sequence of numbers observed by Leonardo Fibonacci, which is are recurring ratios in the patterns of nature. Little did we know that these ratios also apply in trading. These ratios are 23.6, 38.2, 61.8, and 161.8. Later, 50 was added to the sequence of ratios. Other ratios are derived from these basic ratios which are also later added to the sequence.
The Fibonacci Retracement tool makes use of these ratios as a marker of how deep the price has retraced and where pullbacks can probably bounce back. Many traders would say that the optimal pullback is at 61.8, which is also known as the “golden ratio”.
The Fibonacci Extension tool on the other hand is a tool, which is also based on the Fibonacci ratios. This tool predicts how far the price can bounce based on the length of the prior rally or drop while also using the Fibonacci ratios.
Trading Strategy Concept
This trading strategy trades is a basic trend continuation strategy that trades on pullbacks within a trending market.
To objectively identify trending markets, we will be using the Supertrend Indicator. This will allow us to easily identify and confirm trending markets based on the color of the Supertrend line, the location of price action about the line, as well as the color of the shaded area.
As soon as we identify the trend direction, we can then observe for possible pullbacks. We would then use the Fibonacci Retracement tool to help us identify the area where we would observe for possible pullbacks. This is done by connecting the swing points of the pulsing price swing in the direction of the trend before the pullback. Then, we could wait for the price rejection to develop in the area between the 50% and 61.8% Fibonacci levels.
The Fibonacci Extension tool is then used to project the possible target as pulses back in the direction of the trend.
Buy Trade Setup
Entry
- Price action should generally be above a green Super Trend line indicating an uptrend.
- Identify the latest swing low and swing high and plot a Fibonacci Retracement line from the swing low to the swing high.
- Mark the area between 50 and 61.8 and wait for reversal patterns to form as the price touches this area.
- Enter a buy order as soon as a bullish reversal candlestick pattern forms.
Stop Loss
- Set the stop loss below 61.8.
Exit
- Plot the Fibonacci Extension tool from the swing low to the swing high, and the second leg from the swing high to the low of the pattern.
- Set the take-profit target at level 100 of the Fibonacci Extension.
Sell Trade Setup
Entry
- Price action should generally be below a red Super Trend line indicating a downtrend.
- Identify the latest swing high and swing low and plot a Fibonacci Retracement line from the swing high to the swing low.
- Mark the area between 50 and 61.8 and wait for reversal patterns to form as the price touches this area.
- Enter a sell order as soon as a bearish reversal candlestick pattern forms.
Stop Loss
- Set the stop loss above 61.8.
Exit
- Plot the Fibonacci Extension tool from the swing high to the swing low, and the second leg from the swing low to the high of the pattern.
- Set the take-profit target at level 100 of the Fibonacci Extension.
Conclusion
Trend continuation trading strategies trading on pullbacks are a staple type of strategy among trend-following traders. The key elements that traders should identify when trading this type of market are correctly identifying trending markets and trend direction, the correct area where pullbacks may occur, and the appropriate signals indicating the resumption of the trend.
This strategy systematically answers these key elements using the Super Trend indicator, as well as the Fibonacci Retracement and Extension tools.
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