Published On: Tue, Feb 5th, 2013

Trend retracement strategies

These strategies are popular because they enable you to trade with the trend. The main difficulty you will have is how to determine whether a price is performing a retracement or a major reversal. This distinction is very important because you need to know if price is undergoing a more permanent decline or just a temporary dip.

For example, many traders have experienced the frustrations caused by closing their positions prematurely only to then watch price accelerate back in their original chosen direction. To overcome this major drawback, you must know how to identify and trade retracements properly.

So what exactly are retracements? They are price reversals that are produced temporarily within a larger price movement. Their most important feature is that they do not last for long before price resumes its original direction. You need to how to distinguish price retracements from the more serious and permanent reversals by using the following key differences:

  1. Retracements do not produce large increases in trading volume. In contrast, major reversals are generated by the intense selling of professional financial bodies.
  2. Retracements do not generate many notably chart patterns and the ones they do are mainly limited to a few minor candle patterns. Reversals are very serious events and can create numerous famous chart formations.
  3. The retracements are temporary and do not normally last for longer than a week. Reversals have much longer lifespans and may last for weeks, if not, months.
  4. Retracements are created shortly after large price movements have been initiated whilst reversals can occur at any time.

Why is it so important to distinguish between retracements and reversals? This is because traders have to contend with difficult decisions whenever reversals occur. For instance, should they hold their positions open but risk a serious loss? Alternatively, they could sell at the first signs of a price drop and then re-buy at a more favorable discount. However, they then risk the chance of losing larger gains if price should suddenly surged back in its original direction.

Common technical indicators that are used to monitor retracements are:-

  1. Fibonacci retracements.
  2. Trendline levels.
  3. Supports, resistances and pivot points.

Fibonacci retracements were designed to forecast the scope of corrections when trends are prevalent. The most common retracement levels used to achieve this goal are the 61.8%, 50% and 38.2%. You can anticipate price retracing to the 38.2% Fibonacci level during a strong trend whereas it could correct as far as to the 61.8% one during weaker ones. The 50 % retracement level is the one that is most commonly used and is a key area to buy in up-trends or sell in down-trends.

 retracement 1

 The above diagram displays the Fibonacci levels (blue lines) associated with the upward price movement represented by the red sloping line. The three most popular Fibonacci levels at 38.2%, 50% and 61.8% are all shown.

Trends create price channels which have an upper boundary or trendline and a lower boundary or trendline. Retracements always bounce off these trendlines before the price resumes its original direction. A reversal, however, will break through a trendline. The following chart illustrates these features.

retracement 2

Professional traders use pivot points to identify important support and resistance levels. A pivot points, supports and resistances are values against which price often rebounds. For example, breakout specialists utilize pivot points to identify important levels that need to be breached to confirm a true breakout. In the following diagram, R1 and R2 are resistances; P represents a pivot point and S1 and S2 are supports.

retracement 3

Despite all cautions, a retracement can quickly convert into a full-blown reversal without warning. To protect yourself against serious loss, you need to implement a sensible stop-loss strategy based on risk and money management concepts. For example, many traders place their stops just below the long-term trendline support, if long and just above the long-term resistance trendline, if short.

Once you can distinguish a retracement from a reversal as well as determining its scope, you can then design a trend retracement trading strategy to help identify the birth of new price trends or channels. You can then use one of the three techniques just described to help you detect trend retracements.


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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.