A veteran trader breaks down the technical-analysis tool he uses to singlehandedly determine when to enter and exit a trade

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A veteran trader breaks down the technical-analysis tool he uses to singlehandedly determine when to enter and exit a trade

Shain Vernier's uncle introduced him to trading in 2010. Since then, it has become his full-time profession. Today, he mainly trades crude oil, gold, and currencies using a technical-analysis tool called Fibonacci retracement. He's also a teacher and coach helping others learn how to chart at HowToTrade.com.

While many trading tools and indicators can be used to chart price action, Vernier says every market participant needs to find the most sensible combination for their own purposes.

"My dad was a builder; he was a developer. I spent a lot of years on job sites working in the construction industry," Vernier said. "I always understood tape measures. I always understood how to measure things. And all Fibonaccis do with price action is measure them. We're just looking for proportions of price moves. And to me, that made great sense."

Fibonacci retracements are drawing tools and chart indicators that can be applied to both uptrends and downtrends in an asset's price. The philosophy for using them is that these trends will continue in the long term, and the way to make money is to trade around short-term price reversals.

The first step in employing the strategy is setting a range for an asset price between the high and low extremes over a specific period. These points on a chart are referred to as the "swing high" and "swing low," and they are determined by inflection points that span multiple "candles."

As shown in the chart below, a high is a "swing high" (upper candle #2) if it has a lower high on the left side (upper candle #1) and a lower high on the right side (upper candle #3) as well. On the other end, a low is a "swing low" (lower candle #2) if it has a higher low on its left (lower candle #1) and a higher low on its right (lower candle #3).

Once that range is set, Fibonacci retracement levels are set 23.6%, 38.2%, 61.8%, and 78.6%, in alignment with a mathematical Fibonacci sequence. In an uptrend, as shown in the above and below charts, the low point of the range at 100%, and the peak is 0%. In the case of a position exit, 50% is also a relevant level, as shown below.

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Once the upside range is established, traders maneuver around those levels. The chart below shows an asset price that's near the top of its range that's fallen enough to approach the 38.2% level in the sequence. As part of the strategy, someone might buy once the price reaches that support, with the general idea being that the asset will rebound and continue higher.

The next step is figuring out when to exit. Vernier says he follows a set strategy regardless of whether the underlying asset cooperates and pivots directions, or keeps moving the way of the longer-term trend.

If the asset price does, in fact, reverse higher upon reaching the retracement level, he sells it before it reaches the next one. So if the trader bought at 38.2%, they should sell at some point before the asset rebounds beyond 23.6%. The exact timing of that is ultimately up to a trader, based on their risk threshold.

In the event of a "loss scenario," where the asset continues lower, he recommends having a stop-loss set up before the next retracement level — so in this case, 50%.

This same process can be applied to a downturn, although the trader will be instead be shorting, as a bet the asset price will continue declining in the longer run. Further, the range high will represent the 100% level, while the low will be 0%. (Note: Vernier did not unpack the downside shorting scenario in his discussion with Business Insider, citing nuances that make it more complicated than simply buying an asset.)

For example: a trader sees an asset-price rebound to the 61.8% retracement level, while still remaining in the range for a longer-term downtrend. Once it reaches that point, they short the asset. If they are directionally correct and the price then reverses lower, they would close the short before it reaches the 50% level. If the trade doesn't work out, they have a stop-less set before 78.6%.

In simple terms, you're trading the middle. You're trying to follow the prevailing trend to capitalize on longer-term momentum, rather than trying to predict price action or where the top or bottom will be, Vernier said.

There are a couple of caveats. First, Vernier warns traders against using the 23.6% level as an entry point, because it's typically too early to confirm a trend. Second, he says every Fibonacci level should be traded in isolation from other potential entry points.

Like any trading strategy, there is always a risk. Typically, the greater your position size and the longer duration of your position, the greater your risk exposure.

The Fibonacci tool is also only meant to be used in volatile markets. Vernier notes that the chart pattern is not recommended when there is no volume and the market is flat.

The chart below demonstrates the different between a volatile market where the Fibonacci tool can be used versus a flat market where it is not recommended.

The real art form of this tool is being able to pick trading ranges most relevant to the underlying security, commodity, or currency being traded, he said. Knowing this range comes with the experience of trading an underlying asset; therefore, this tool is not for beginner traders.

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