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12. Trading Trend Retracements

  • A specific trading strategy where the idea is to trade in the direction of the trend, but enter on retracements.
  • How to spot the best entry level using pivot points, support and resistance levels and Fibonacci retracement areas.
A very popular forex strategy is to trade trend retracements which has one major advantage among others: you are actually trading with the trend. However, how can you determine whether a price is performing a retracement or undergoing a major reversal? This distinction is very important because you need to determine if a price decline is of a long term nature or just a mere relief dip. For instance, many traders have experienced the frustrations caused when they have closed positions prematurely only to watch the market price accelerate in their originally chosen direction. To overcome this major drawback, you must know how to identify and trade retracements properly.

So what exactly are retracements? They are temporary price reversals that occur within a larger price trend or channel. Their most important feature is that they do not last for any great length of time before the trend resumes its original direction. There are several key differences between a retracement and a reversal that should help you to make the correct distinction:

1. Retracements are usually caused by small traders taking profits and as such do not produce large increases in trading volume. Full reversals are normally driven by large institutional selling or buying and generate significant increases in trading volume.

2. Retracements produce few serious chart patterns and the ones they do produce are mainly minor candle patterns. Reversals, on the other hand, are very serious events and are capable of producing major chart formations such as double tops or head and shoulders etc.

3. The lifespan of retracements are usually very short and so do not last normally for longer than a week or two at the most (often only a day or two). Reversals are more permanent events and may last for weeks or months.

4. Retracements are born normally after large price movements have occurred while reversals can occur at any time.

5. A reversal from a long term trend is caused by fundamental changes. Technical analysis can help in pinpointing entry levels, but do not expect a long term reversal to be caused by technical analytical elements.

Trading Trend Retracements

The reason for the importance of this distinction is you have to deal with difficult choices whenever price retracements occur. For instance, should you hold your trade but risk a substantial loss if a full blown reversal is fully formed? Alternatively, you could sell at the first signs of a price drop and then re-buy at a more favorable level. However, you risk the chance of losing larger gains by doing so, should the price suddenly surged back in its original direction. A further choice is that you could just close your trade completely but then you could face losing a significant profit opportunity if the price makes a full recovery and more.

As soon as you have determined a method to help you detect a retracement, you will need to devise a technique to enable you to determine its scope. The most popular tools for undertaking this task are:
  • Fibonacci retracements.
  • Trend line support and resistance levels.
  • Horizontal support and resistance pivot point levels
Fibonacci retracements are percentage values which can be used to predict the length of corrections in a trending market. The most popular retracement levels used for the forex market are 38.2%, 50%, and 61.8%. In a strong trend, you can expect the currency prices to retrace by a minimum of 38.2 percent whereas weaker trends produce corrections that may go as far as 61.8%. The 50 % is the most widely monitored retracement level and is a common area to buy in up-trends or sell in down-trends.

The most common Fibonacci levels that are used by traders are 50% of a trend and 61.8% of a trend. These are the levels at which the currency price often tend to reverse back during a retracement. If the level holds and you are able to create an entry at that point, you could activate a trade that has an excellent risk:reward ratio. Many traders activate trades at one Fibonacci level while placing their stops on the over side of the next one e.g. buy at 38.2% with a stop on the over side of 50%. However, although using Fibonacci can be a good way of defining entry points, it might be a better idea to look for other options when defining a stop loss for the same trade. A typical mistake is that traders become too impatient and enter trades before the trend has actually formed. They also have a tendency to assume, for example, that the 38.2% Fibonacci level will hold without allowing enough time to monitor exactly what the market will do. If you want to enter a trade, based on Fibonacci, then wait for the pair to hit the level, and watch it bounce off at least on the 1 hour time frame, and then consider entering a trade.

Trends create price channels which have an upper boundary or upper trend line and a lower boundary or lower trend line. Retracements tend to bounce off these trend lines before the price resumes its original direction. A reversal, however, will break through a trend line.

Professional traders use pivot points to identify important support and resistance levels. A pivot point and its associated supports and resistances are levels at which the direction of price movement can possibly change. For example, breakout traders use pivot points to recognize key levels that need to be broken for a move to be classified as a real breakout.
Despite all cautions, you must understand that a retracement can quickly convert into a full-blown reversal without warning. To protect yourself against serious loss, you must devise a sensible stop-loss strategy. To accomplish this, many traders place their stops slightly below the long-term trend line support if long and slightly above the long-term resistance trend line if short.

Once you have located methods to help you distinguish a retracement from a reversal as well as determining its scope, you are then well placed to deploy a trend retracement trading strategy.

You could use the breakout strategy to define the birth of a new price trends or channels as discussed in the last chapter.

Afterwards, you can then look for retracements to help you activate trade entries with good potential profits at minimum risk. Once a trend drops to one of its trend lines, you should consider activating a trade entry. You should also set a protective stop on the other side of the trend line to protect yourself from a full reversal. If you are unable to clearly see a trending channel on the chart of a particular currency pair, then leave it and study others. To be successful at this type of trading, you definitely need to identify a clear trading pattern without any complications. Also remember that you do not want to activate a trade in a trend that is just forming as it may be a fakeout. Similarly, be careful if a trend has been in existence for some time as it may be coming to the end of its life. In addition, do not apply this technique during times when major fundamental releases are imminent because of the potential high levels of volatility that could result.

The information in this chapter and previous ones will help you protect yourself from these problems. Basically, be patient and wait to the end of the closing period in question to allow yourself enough time to evaluate the position accurately.

In conclusion, a forex strategy based on trend retracements provides excellent opportunities of locating re-entry points at minimum risk and with excellent profit potential.

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