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Splitting a Trading Range Using Fibonacci Retracements:
Price breakouts aside, as long as the asset is still range bound; there are definite opportunities for profitable trading. While the strategy seems obvious – call options near support levels and put options near resistance levels we will go a little deeper than that.
First, the theory behind Fibonacci retracement levels, which are all based on the ‘golden mean’ of 1.618 or its inverse, 0.618. There are 5 Fibonacci retracement levels to know: 23.6%, 38.2%, 50.0%, 61.8%, and 76.4%. For background reading on the brief history of the Fibonacci sequence and the source of the various Fibonacci retracement levels, this article is an excellent resource.
Let’s take a look at our previous chart example, but now with the Fibonacci retracement levels mapped out. Note that this is just a rough visual example, and further, for the purpose of this range-bound trading strategy, we are excluding the 38.2% and 61.8% retracement level. A good trading platform should come with a built-in Fibonacci retracement tool option.
So, in terms of call and put options, whenever the price of the asset is between the 0% and 50% level, the lower half of the range, we will be looking at purchasing call options and when it’s between the 50% and 100% level, the upper half of the range, we will be looking at purchasing put options. This is the most basic strategy at the heart of range-bound trading and the 50% level represents the first split in the range that we can utilize.
Now we split the range even further, utilizing the 23.6% and 76.4% retracement levels to determine the best type of option to use in the situation. The general rule is the following: when the price touches the 23.6% level or the 76.4% level, we will be looking at purchasing one touch options with the strike price of the one touch option being the 50% retracement level. One the other hand, when the price of the asset touches the support or resistance levels (0% and 100%) then we will be looking at the traditional high/low options (calls and puts, respectively) with longer expiration dates. Let’s illustrate this on our chart once more (using only the lower half of the range to avoid visual clutter).
If you would like to split the range even further, then the 38.2% and 61.8% levels can be reintroduced. Note for instance on the second ‘one touch’ level from the left of the chart that depending on your expiration date, the price may not reach the 50% level, however it would have reached the 38.2% level. We can see this also at the top half of the chart where at certain points when the price touches the 76.4% level that a strike price at the 61.8% level would have been more appropriate.
While Fibonacci retracement levels are an excellent technical analysis tool in range bound trading strategies, it is not the be-all-end-all or even 100% certain. Nevertheless, it is an effective tool in a trader’s arsenal and all traders should at least have a surface level knowledge of Fibonacci retracements.
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