What is retracement in forex? And how do I trade retracements?
Very comprehensive explanation for all newbiesA retracement is when a currency pair reverses its direction and moves in the opposite direction of a previous trend.
Forex pairs usually move in trends or sideways. That is, sometimes, buyers or sellers prevail, and the market is predominantly one-sided and moves in one direction. In such a case, the market is moving in a trend.
Despite this, markets hardly move in a straight line. They usually move in zigzag shapes or waves. Thus, even in an uptrend, you see some downwards pull back movements. This happens because even if the buyers are prevailing, there will be some sellers from time to time, and people have different convictions about where the market is heading usually.
After a trend, the market usually reverses some or all of that movement. Traders often call that reversal a retracement. Sometimes this happens because some of the traders exit their earlier positions and book some profits.
It is typical for markets to retrace 23.6 percent, 38.2, 50 percent, or 61.8 of their earlier movements. Thus, traders often find the Fibonacci retracement tool to be handy in identifying those levels.
There are two ways to trade retracements: either with the original trend or against it.
To learn more about retracements and reversals read this chapter of FPA Forex School
- Those who want to trade with the original trend assume that the price action will resume the earlier trend after a retracement. They wait for the price to bounce off of one of the retracement levels mentioned above (often the 50 percent level) and then enter a position. Here, there is a risk that the price does not continue in the direction of the original trend and continues its reversal.
- Those who want to trade against the original trend, i.e. with the retracement, assume the earlier trend won’t last. They use the retracement levels as support or resistance levels and enter a position when the price has displayed some sideways movement then continued in the direction of the retracement (i.e. broke out). Traders then assume that the momentum of the original trend has waned, and a new trend is in the making.
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