Published On: Mon, Jan 28th, 2013

‘Trading with the Trend’ Strategy

Strategies based on trading ‘Trend Retracements’ have become popular because they primarily allow you to trade with the trend. However, you will only be able to perform this method well if you learn how to differentiate between when price is undergoing a mild retracement or a full-blown reversal.  Understanding this difference is critical because you need to be able to distinguish between when a currency pair is experiencing a minor correction as opposed to changing direction completely.

Perhaps you have already closed positions prematurely after price has reversed its direction towards them only to then witness in frustration as it rebounds and proceeds back into its original path. To counter such difficulties, you need to learn how to detect retracements proficiently.

To accomplish this goal, you first need to know what a retracement is exactly. Essentially, they are price reversals that are just temporary in nature. They normally occur when price is trading a strong trend and undergoes a minor correction. Their most important characteristic is that such reversal movements are limited in size before price resumes its original path. Distinguishing between retracements and reversals is the key to trading this type of strategy successfully.

How can you do that? To do so, you need to appreciate that there are a number of significant differences between retracements and reversals.

1. Retracements are often created by the smaller investors taking profits and do not generate any meaningful increase in trading volume. In contrast, reversals result from the intense selling activities of major financial institutions which are capable of producing large increases in trading volume.

2. Retracements are not associated with any major chart patterns and are only identified with a few simple candlestick formations. As reversals are very important events, they are responsible for the creation of a number of famous candlestick configurations such as ‘head and shoulders’ and ‘double tops’, etc.

3. Retracements exist for short periods of time only, i.e. one to two weeks at the most. Reversals have much longer lifespans which extend from weeks to months.

4. Retracements are components of a larger price movement and represent just temporary corrections. Reversals are the main price movement and can be created at any time.

Distinguishing between retracements and reversals is very important. This is because you will need to make difficult decisions whenever you notice that price is beginning to reverse. For example, should you keep you position active but risk a major loss if a full-blown reversal evolves?

Should you close your trades immediately whenever price begins to reverse direction? You would then have the opportunity to activate a new position in your original direction at a superior discount.  However, such an action could lose you valuable profits should a retracement propel price back into its original path.

Essentially, you will need a technique to assist in detecting retracements and then determining the size of their scope. Investors normally use the following technical indicators to perform these tasks:

1. Fibonacci retracements.

2. Upper and Lower Trendlines.

3. Support, resistance and pivot point levels

Fibonacci retracements are percentage numbers that can be deployed to predict the size of price corrections within a strong trend. The major retracement levels are 61.8%, 38.2% and 50%. Price tends to retract to the 38.2% level during stronger trends. In comparison, it will correct as far as 61.8% during weak trends. The 50 % is normally used to open long positions in up-trends and shorts in down-trends.

Trends are price channels that are delineated by an upper and lower trendlines. During retracements, price usually rebounds against trendlines before proceeding in its initial direction. In contrast, a reversal will penetrate a trendline producing a brand new price channel.

Pivot points and their related supports and resistances are levels at which price frequently bounces against before changing direction. For instance, you could utilize these important technical indicators to help you identify major levels that price needs to breach in order to create full breakouts.

Despite protecting your account balance with all essential safeguards, retracements can transform instantly into a major reversals placing your equity at high risk. To counter this serious problem, you must develop or attain a well-tested money management plan. You can then accurately determine stop-losses and position-sizes for each of your trades so that your balance is well protected against all eventualities.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.