The next trend following strategy involves trading pullbacks and using the Fibonacci retracement tool and the Relative strength index (RSI) to pinpoint reversal levels. A period setting of 14 is recommended for the RSI.
Every trend will experience short-term setbacks when the price trades against the main trend, and the purpose of this strategy is to enter in line with the trend when a correction or pullback is about to end. The pullback can be used to enter the existing main trend at a favorable price, and better good risk-reward ratio than trading breakouts. However, the risk of trading a pullback or correction is that it can be the start of a trend reversal.
Using Fibonacci retracements
In the following trend following strategy, the main trend is derived using the daily time frame. The measure of the extent of the correction can be calculated from Fibonacci retracements. According to Dow Theory, the price usually retraces around 50% of the initial move. However, the Fibonacci retracement levels are 38.2% and 61.8% of the initial move and allow for a more precise entry than just buying or selling outright at the 50% correction level alone.
It is advised to look at Fibonacci levels as zones, which means that the price does not have to hit the exact Fibonacci level. This is because, corrections tend to reach a zone between 38.2% and 61.8%, almost always before the underlying trend resumes.
Using the Relative Strength Indicator
The RSI or Relative Strength Indicator is mainly used for identifying both overbought and oversold price levels. This is helpful in attaining an additional confirmation before entering the market. Always look for an RSI level which is above 70 for an overbought signal and under 30 for an oversold one.
One of the best approaches in using this technique is through Multiple Timeframe Analysis. The MFTA refers to analyzing the price-action on different time frames. This is done to identify the longer-term trend, short term corrections and most importantly, the perfect entry point to enter a trade. Thus, we will look for trends on the daily time frame and using the 4-hour time frame to enter in the direction of the trend. All entries will be based on market corrections.
The first step involves identifying the daily trend’s direction. In the breakout strategy article, we showed you how the AUDUSD was in a downtrend. We are using the same market here and we can see how the price is clearly creating lower highs and lows. I have highlighted a clear swing high in this downtrend and we will use it as the stop level for the position.
Even though the definition of a downtrend states that the trend will be downwards if the price is creating lower lows and highs, I always place more emphasis on the highs rather than the lows in a downtrend. I do the opposite in an uptrend i.e. I focus on the lows.
AUD/USD in Bearish Downtrend Chart
Combining Fibonacci and RSI to enter the Trend
Here, we know that the overall market direction is down, and we can switch to a four-hour time frame, looking for trading opportunities to short-sell the AUD/USD currency pair. This is achieved by combining Fibonacci retracements level as well as the RSI indicator. In this context, we have to enter short, and the RSI should be in the overbought area.
It should be noted that markets can stay in the overbought or oversold levels for a long time in the case of the RSI. This is the main reason why traders should avoid trading solely based on technical indicators like these. They are thus used best as confirmation tools which can help you to enter either a long or a short position inline with the overall trend.
The Fibonacci tool is then applied by connecting the previous high and low points. Use any trading platform to automatically draw the Fibonacci retracement levels on your chart. The strategy will only work if you figure out the true trend-defining level as explained above. A test to know if you are good at identifying the correct levels is if the market will not look back after crossing your level. In the example below the 0.7814 level was the last swing high and trend defining level, and a break to this level would probably have started a bullish trend.
The short term correction finds resistance at the first Fibonacci level at 0.7564, and the RSI was also overbought as highlighted by the first red arrow. The price traded lower, but a few days later it revisited the highs and reached the third Fibonacci level at 0.7659, also here RSI was overbought. Eventually, a few days later the price slid to 0.7308, and on the first position, we would have made a profit of 254 pips, followed by 346 pips in the second position. The difference between the first entry and the stop was 252 pips, while the difference between the second entry and the stop level was 153 pips. The total risk was 405 pips vs. a total profit of 619 pips, and this provided a risk-reward ratio of 1.52.