Fib extensions w/ zig zag trend trading strategy

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This is a trend following strategy that uses fibs extension levels along with the zig zag indicator to enter into market retracements.

The fib levels used are;

1.27 (needs custom added in MT4)
1.61
2.20 (needs custom added in MT4)
2.61
3.20 (needs custom added in MT4)

The strategy places pending orders on the first 4 fib levels when price is retracing in a trend. The are various variables that can be applied to this strategy depending on the market conditions and some other considerations but the 4 pending orders on these levels are a constant.

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The fibs can be drawn from either the last swing to make a new high in the trend or on the last swing in the direction of the trend.

Using only swing highs. The fibs on this chart would have been static through all the recent price action, using the last trend swing, they dynamically moved and would currently be as shown.

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There are pros and cons to using each method.

The main con with using only the swing highs is when there is a very strong one way move and it draws a large zig zag line (as in the example shown), the fibs extend very, very far away from CMP and it misses many moves.

The main pro with it is that it tends to define very strong levels where a very high percentage of the time there will be a bounce from the 261 into the 161 area. Only in more rare extremely strong reversals does price tend to crash through all these levels without retesting the 127 - 161 zone. This gives various exit options on the 4 trades that can result in profit or break even on a high percentage of trades.

The main con with using the last swing in the direction of the trend is when there are very shallow zig zags drawn. These in turn give shallow extensions and increases risk of whipsaws.

The main pros are it can generate far more profitable trades and good entries.

Using the same EURUSD chart it can be seen how it picked out the low of the move. (There was a very shallow zig zag after the one drawn on that would have filled 1.27 - 1.61 also but would be too small to show well in screenshots).

The 3.20 level is there to serve as the final line before stop losses. All stops should be placed no further than a small amount of pips (a few multiples of the spread) behind this level. This is large stops on the 1.27 and 1.61 trades and there are options to stop them out sooner also. It is an ideal stop for the 2.20 and 2.61 levels.

Money management options, targeting and more on stop placement in following posts.

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Stops and Targeting

Herein, the 1.27 -1.161 levels will he referred to as “zone 1” and the 2.20 - 2.61 areas as “zone 2”.

As mentioned above, behind the 3.20 level is a good stop level for zone 2. More aggressive stops can be used placing the stop in the middle of the 2.61 - 3.20 levels but can be prone to whipsaws when price wicks through the 2.61 before reversing.

Similarly, stops from zone 1 can be placed tighter by placing them in the middle of the 1.61 - 2.20 levels but runs the same risk of whipsaws (vastly increases the RR from placing zone 1 stops behind 3.20, though).
In targeting, the main trade off is the decision whether to go for high RR payoffs or a high volume of profitable/break even trades.

First, the is the option of using zone 2’s trades as a recuperation trade to cover losses from zone 1 breaking (assuming stops all placed behind 3.20).

This is, trading from zone 2 using a target of zone 1 (typically the 1.61 level will be good for this, it will offer around 1:1 RR on the 2.20 trade and 1.5 RR on the 2.61). Using different styles of money management or exiting the zone 1 trades at reduced loss when zone 1 retests and zone 2 targets hit can limit drawdowns in a deeply correcting market, or even a reversing one. More on this later, first, an examination of how price commonly reacts at these levels and when it would be most advantageous to use this style of exiting zone 2 trades.

The bulk of losses this strategy would be expected to generate when using the last swing in the direction of the trend (the more dynamic of the two options) is of course when the trend starts to reverse, or even put in a deeper correction (side note, these deeper corrections are often well picked up using the last high method) since as the market start to roll over the will be multiple failed rallies, thus causing multiple bullish zig zag lines to draw new fibs from that. Therefor, each little rally potentially sets up a block of 4 losing trades. This is where the strategy would incur most drawdown/losing streaks.

This can be greatly offset by using zone 2 as an area to look for a short bounce target rather than a larger target (which would be, looking for trend continuation).

The above chart is a GBPYJPY weekly chart and shows a strong one way reversal. This is a bad scenario for a trend following strategy, Depending on the criteria used to determine when to stop trend trading, a bullish trend following strategy would have sustained multiple losses and certainly would have been unable to avoid any losses as the market rolled.
On the weekly chart, the strong move down would have not formed many bullish zig zags and thus filtered out many potentially losing trades. In fact, only one setup was formed for both the last high and last swing (last high losing and last swing offering break even or profitable scenarios).

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The losing signals would have been generated a lot more on the smaller charts, though. Using the 4 hour chart it can be seen how signals were generated that despite trading against the direction the market ultimately went, offered profitable/break even opportunities depending on money management and exiting.

This was a strong falling market and in many cases the bounces from zone 2 were shallower and would have resulted in stop outs but these would have been at least partially covered if using a method of using zone 2’s trades to cover zone 1’s. Again, there are a few ways this can be done, to be covered later. The point for now is, unless it is a strongly trending asset putting in a retracement over 60% or a reversal, even when moving against the strategy, the rarity of price continuing to extend so many multiples of a previous swing without correction so as to run directly through the 3.20 without retesting the 1.61 allows this strategy when used like this to make profits or at least stem losses in non ideal conditions.

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Here is a current example on oil showing an example of how this could have negated losing trend following trades if this happens to be a turn in the oil market. Notice the 3.20 acting as support and price is now near the 1.61, an area at which it would be possible to exit all trades without loss.

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Using this method can win a lot of trades. However, it gives up a lot on RR. Both on the risk and reward side.

Assuming symmetric risk is used (for example, 4x 0.5% positions to risk a net 2% on the trade).

Given the large stop, behind 3.20, the RR on zone 1 trades can only be around 1:1 or slightly better. The trouble here comes in when there are shallow retracements and trend continuations.

Shallow retracement fill only the 1.27 and perhaps 1.61 but entirely miss zone 2. Using 0.5% risk on both and hitting 1:1 on both, returns 1% for a net risk of 2%. If only the 1.27 fills, only 0.5% is made. Using zone 2 to recover zone 1 for break even trades offers no return so the max gain to be made is 1% or less, whereas a stop out will always generate a 2% loss. Although there will often be a high win rate, it is going to be prone to overshoot corrections or reversals wiping out multiple winning trades. In a worse case scenario, a win rate of 75% is required to break even.

This can be greatly improved by adjusting the targeting on the zone 2 trades.

If using a retest of the previous highs as the target, zone 2 will usually offer 3:1 and 4:1 RR trades.

Now, the overall risk is still 2% but the overall payout is potentially;

0.5% + 0.5% + 1.5% + 2% = 4.5%.

There will still be the little wins when there are shallow retracements and there will still be the 2% stop outs when there are large, strong counter moves but a full payout scenario covers over two full stop out scenarios.

Aggressively targeting a trend continuation (new high) pushes this potential maximum gain up to around the 7% mark.

Making situations like these very profitable.

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Money Management Options

Different money management options can be used for different desired outcomes and risk appetites.

Already covered was a set risk of x% per trade split into 4 equal trades but there are also other options.

In a strongly trending market, zone 1 trades may take more risk since they are expected to fill and reverse more often (ie, zone 2 does not come into play often and to capitalize on the trend most risk is used in zone 1, with a smaller add on at zone 2).

Another option is to use increasing lot sizes.
A simple way is to use 1 step incremental lot sizes.

Eg,

1.27 = 0.1 lots
1.61 = 0.2 lots
2.20 = 0.3 lots
2.61 = 0.4 lots.

This allows a net profitable position if price runs zone 1 and retests it from zone 2 and all trades are closed on the retest of the 1.61%.

It also means zone 2 about covers the entire risk of zone 1’s stop out if profits are taken on the 1.61. Therefor, zone 2’s trades could close and eliminate most of the risk from zone 1’s trades and they could be left to run to see if the trend continues, or conservative targeting could put the take profits at a retest of the treend continuation.

Here is an example of what that would look like.

In the variation where zone 2 targets aggressively, the profit potential for this is large, since the largest positions have the smallest stops and the largest targets.

From the 2.61 to the retest, will usually give at least 4:1 RR. This one trade hitting a take profit will cover an entire 4 trades stop out. With the other three trades adding up to also cover a bit above the entire risk.

Implementation of trailing stops losses from zone 2 into breakeven when the price is back at zone 1 can give situations where there is the potential for a large pay off with only a small amount of risk on.

The most aggressive version of this, of course, is martingale.

Martingale (set at a maximum of the 3 trade size increases) has the potential to be hyper profitable in good trend moves and also have profitable situations even when price runs against the strategy when zone 2 is used as a recovery zone.

For a simplistic example, if 1% is used on 1.27, 2% on 1.61, 3% on 2.20 and 4% on 2.61. There is a net risk of 10%.

1.27 target 1:1.
1.61 target 1.5:1
2.20 target 1:1
2.61 target 1.5:1

Net potential return on all targets hitting - 12.5%.
Return on only zone 2 hitting = 7% - 3% - 4%.

Again, this slips into the trouble of there potentially being a lot of smaller wins from zone 1 not building up enough to cover the 4 position stop outs but can have a high win rate. In a persistent trend it should do well.

Aggressive targeting;

1.27 target 1:1.
1.61 target 1.5:1
2.20 target 3:1
2.61 target 4:1

All targeting hitting returns 29%. (For 12% risked)

Considerations for best time frames to be used and market conditions this strategy suits in following posts.

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Current example on EURUSD.

Two things to look for;

1 - Confluence of structural SR in at the fib zones. (See circled).

2 - Even if the first fibs break, price stalls or failed reversal candles (pin bars etc) forming on the fibs to show they have some relavence to price action.

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Here is another version using the bigger swing.

In this larger swing, price has only filled zone 1 trades. Zone 2 trades would be picked up deep into the retracement giving big RR trades if price continues downwards.

In both variations the lots increase the further away from CMP they are.

In variation one, a doubling method is used. In variation two, a set amout of risk is used on each trade but since the stops get smaller the lots get larger.

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Ideal Market Conditions and Timeframes.

As with all trend follow strategies, the best conditions are of course trending one.

Herein lies a bit of a paradox, though. Since too strong a trend will not work well with the zig zag indicator, since the swings are large and long, rather than splitting into multiple little zig zags.

This can be seen using zig zags on BTC, despite it having had trending moves, it would not have provided a single set up over the last couple years using zig zags.

For this reason, the strategy often works better on smaller timeframes, 15 mins - 4 hour charts.

The reason behind this is simple, while a daily chart may show some strong days of movement on a Forex pair, gainimg 300 pips, ending show only a few strong daily candles, not indicating pull backs in they candles, examining the same price action on a 15 minute chart will typical show it advancing 50 pips, pulling back 20, advancing 70 pips, pulling back 30 … and so on.

This smaller break down of the swings will form more zig zags, which will provide more instances where zone 1 and zone 2 will be usable for retracement moves.

Trends forming in an Elliot Wave type of movement are ideal since they will often provide chances where zone 2 will come in at the end of a deeper correction in the EW leg “C”. When this happens, it gives zone 2’s trades a minimum of 3:1 RR (retargeting the high).

In short, there needs to be trending movement but the trend also needs to feature (usually quick) corrections after price makes “head fakes” into new extremes in the trend and then quickly pulls back to retest previous breaks.