The Fibonacci Fractal Retracement trading strategy is a popular trading strategy that uses the fractal indicator to determine the nearest swing high/low and uses Fibonacci levels to determine the retracement point.
How does the Fibonacci sequence work?
The Fibonacci sequence is a sequence of numbers where after 0 and 1 each number is the sum of the previous two numbers. This goes on ad infinitum:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584, 4181, 6765….
There are some interesting relationships between these numbers that form the basis of Fibonacci trading. While we cannot cover all of these relationships in this article, below are the most important ones that you will need to be aware of when we review the Fibonacci Forex trading strategy later:
If you divide the number by the previous number, it will come close to 1.618. This is used as a key level in Fibonacci extensions, as you will learn later in the article.
If you divide the number by the next largest number, it will come close to 0.618. This number forms the basis for the 61.8% Fibonacci retracement level.
If you divide the number two more places higher, it will come close to 0.382. This number forms the basis for the 38.2% Fibonacci retracement level.
1.618 is known as the Golden Ratio, Golden Mean or Phi. The reciprocal of this is 0.618, and both numbers occur in nature, biology, and space.
How to trade using Fibonacci retracement?
Fibonacci retracement levels help provide price support and resistance levels where a directional reversal can occur and can be used to establish entry levels. Correction levels are based on the previous market movement:
After a significant rise in prices, traders will measure the move from the bottom up to determine where the price can return before bouncing higher and continuing the overall trend higher.
After a significant drop in price, traders will measure the move from top to bottom to determine where the price may return before correcting lower and continuing the overall trend lower.
How to trade the Fibonacci retracement
How does a Fibonacci retracement work?
To use Fibonacci technical analysis, a trader must identify point X, which is the start of a trend. The trader then needs to find a point, this is the point at which the trend reverses and a pullback appears. A Fibonacci retracement must be applied between these two points. If the retracement is no more than 61.8% of the Fibonacci level (point B is not lower/not higher than 61.8%), the probability that the trend will continue in its original direction is high. When point B is defined as the nearest swing high/low and it is not above/below the 61.8% level, the trader should go long during a bullish trend and go short during a bearish one.
Initial back test
For backtesting, we coded a complete Fibonacci retracement trading strategy as a MetaTrader 4 Expert Advisor. Through preliminary analysis, we determined that the best time frame for a Fibonacci retracement trading strategy is 1 hour (H1). We retested the Fibonacci retracement strategy using the standard MT4 fractal indicator to determine swing high/low. For our test, we used a trailing stop of 30 pips as the exit rule, which is triggered after the start of the trade and changes with each new 1 pip of profit. From our point of view, this approach allows you to maximize profits and minimize drawdown.
We tested on 2009.01.01-2021.01.24 using a per-tick simulation on EURUSD-H1 using 1:10 leverage, no reinvestment, assuming a spread of 10 ticks. These are the main parameters of the effectiveness of the Fibonacci retracement trading strategy in its unoptimized state:
ROI -4.6%
Number of transactions 5565
Win rate 36.05%
Max. Drawdown 47.90%
Trade data analysis
After running an initial test of a simple unfiltered strategy, we analyze trading data to identify possible filters to use to make the strategy more profitable while reducing drawdown.
The following charts can give you some idea of what filters should be applied (time sessions, weekday cap, trend strength threshold, overbought/oversold conditions, volatility range) to make this strategy profitable if you decide to use this strategy in your investment portfolio.:
Optimization
The Fibonacci fractal retracement trading strategy can be used with other indicators to filter out losing trades and increase the accuracy of entry signals. After analyzing the trading data, we found the following findings that helped us increase the profitability of the Fibonacci Retracement trading strategy up to 16%, reducing its drawdown by 4 times:
Trades that were entered at too low and too high ADX values seemed to bring more losses when trading the Fibonacci Fractal Retracement trading strategy during 2009-2020. ADX shows the strength of the current trend. It is wiser to enter into transactions at the beginning of a trend.
(ROI increase -4.8% -> 4.8%, drawdown reduction by 47.9% -> 15.87%)
Most of the trades that were entered at a too low Stochastic value, and most of the trades that were opened at a too high Stochastic value, were unprofitable when trading the Fibonacci Fractal Retracement trading strategy during 2009-2020. It is risky to make deals in overbought and oversold zones.
(ROI increase -4.8% -> 1.0%, drawdown reduction by 47.9% ->13.52%)
Most of the trades that were opened at too high and too low RSI values were unprofitable when trading the Fibonacci Fractal Retracement trading strategy during 2009-2020. RSI measures the magnitude of recent price changes to assess overbought and oversold areas.
(ROI increase -4.8% -> 0.8%, drawdown reduction by 47.9% -> 8.62%)
The most profitable trades were opened with an average value of the demarker when trading the “Fibonacci Fractal Correction” during 2009-2020. The demarker is aimed at assessing the direction of the market.
(ROI increase -4.8% -> -4.6%, drawdown reduction by 47.9% -> 43.2%)
Most of the trades that were opened at too high and too low values of the Williams Percent Range indicator were unprofitable when trading the Fibonacci Fractal Retracement trading strategy during 2009-2020. The Williams percentage range is a momentum type indicator and measures overbought and oversold levels.
(ROI increase -4.8% -> -4.5%, drawdown reduction by 47.9% -> 41.2%)
Optimization results
We analyzed the data obtained from testing the Fibonacci fractal retracement trading strategy in 2009-2019 and applied some filters such as Stochastic, ADX, RSI, WPR and DeMarker. As a result, the profitability of the strategy increased from -4.8% to 3.3%, and its drawdown decreased from 47.90% to 4.19% using a leverage of 1:10.
Back test after optimization
Reducing the drawdown by more than 10 times allowed us to increase the leverage that can be used when trading this strategy to 1:35, which in turn led to an increase in ROI on an annualized basis to 116.71%!
The decrease in drawdown also allowed us to use risk-based lot calculation. Below you can see the backtesting results using an opening balance of $10,000 and 5% risk per trade:
ROI 288%
Number of transactions 1124
Win rate 41.21%
Max. Drawdown 46.78%
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Disclaimer: Hypothetical or simulated performance results have certain limitations, unlike real performance, simulated results do not reflect actual trading. In addition, because no transactions have taken place, the results may be under or over offset by the impact, if any, of certain market factors such as lack of liquidity.
Simulated trading programs in general also depend on the fact that they are designed with hindsight in mind. No representation is made that any account will, or is likely to, generate profits or losses similar to those shown.
Past results are not necessarily indicative of future results. The customer is responsible for using the product at his own risk and Robobroker is not responsible for any possible damages caused by the use of the product, including but not limited to damages.
