Retracements In Forex Trading
Retracements are temporary moves against the overall trend direction and eventually result in a trend resumption i.e. retracements can be considered as temporary trend reversals.
In Forex trading, a retracement occurs when the weaker currency overall, has a burst of strength that ends when the overall stronger currency overpowers it again (and the trend resumes). Below is an example of retracements within a prevailing trend.
Retracements example- EURUSD Daily
The exchange rate of EURUSD is falling thus the market is in a downtrend. However, there were periods when prices increased (blue areas), these moves are considered retracements because the end result was continuation of the trend.
How are retracements used?
Retracements represent a momentary shift in the supply and demand of the market, usually the result of profit-taking from the bulls/ bears or reversal traders entering due to a potential top/ bottom.
The keyword is the moves are momentary therefore they can be used to join the trend and ride the momentum of the market. It is as if the stronger side is taking a “breather” before another push.
In uptrends, retracements create higher lows and in downtrends, they create lower highs, essentially, retracements are part of the structure of trends.
Retracements in an uptrend- GBPUSD Daily
A series of higher lows and higher highs is created which defines an uptrend.
Retracements in a downtrend- NZDUSD Daily
A series of lower highs and lower lows is created which defines a downtrend.
Considering that markets are fractal (each timeframe “makes up” the others) it is important to remember that a retracement on a larger timeframe could be a trend on a lower timeframe, this presents the opportunity for trend traders to use the shorter term move to get in at a better price and join the larger trend.
Trends of different timeframes- GBPUSD Daily
Above we can easily see that the overall trend is up but the market did retrace at certain points, on a lower timeframe (such as the H1) each of these moves would be downtrends before continuation of the larger move.
Opportunities arise in these situations to flow with the direction of the tide, but how can you use retracements advantageously? Up next we will look at some common ways to trade retracements.
Approaches to trade retracements
Since the idea is to use retracements to join the overall trend, traders can use technical analysis to determine when the retracement should come to an end and enter with the dominant side. Here are ways to achieve that purpose:
1. Use horizontal levels
Conventional support and resistance levels can be used to determine when a retracement should end, strong levels should be used such as major historical inflection points or current swing highs/lows.
Trading retracements using horizontal levels- AUDNZD H4
On this AUDNZD chart, we can see that price retraced back to the previous higher high on two occasions, these levels act as support and can be used to place buy trades.
During downtrends, lower lows can also act as resistance therefore sell trades can be placed at these levels.
This technique is commonly used when trading breakout retests.
2. Use trendlines
Trendlines act as dynamic support and resistance, because of this they are a great way to determine when the next leg of the larger trend could begin.
Trading retracements using trendlines- CADJPY H4
As shown, the market retraced to the bullish trendline providing an opportunity to place a buy trade with the current upward movement. Bearish trendlines can be used in the same way to sell.
3. Fibonacci retracements
A technical analysis tool designed specifically for retracements. Fibonacci measures the % size of the retracement relative to the size of the impulse wave and favours trend continuation after a relative move against it.
38.2%, 50% and 61.8% are the most traded levels and are treated the same as conventional support or resistance.
Read this to learn more about Fibonacci.
Trading retracements using Fibonacci- GBPNZD H4
In this downtrend example, the Fib is drawn from the high to the low of the impulse wave, price then retraces to the 61,8 level which presents a selling opportunity. The same concept applies to uptrends but the Fib is drawn from the low to the high.
4. Moving averages
Moving averages also act as a dynamic form of support and resistance, retracements to the technical indicator can be an opportunity to buy or sell with the mindset that the probabilities favour price respecting the moving average.
If you are interested in trading moving averages then check out Moving Average Trading Strategy.
Trading retracements using moving averages- CHFJPY H4
During this period CHFJPY tested the moving average on 3 occasions and the indicator acted as support, presenting buying opportunities. Again, the same approach can be used to trade downtrends.
Differentiating between retracements and reversals
Yes, its true, the trend is your friend until it ends. As a trader, you need to be able to notice the signs of a reversal vs those of continuation, the techniques we just discussed to trade retracements are designed to favour trend resumption.
But the aim as a trader is to get the best probabilities, so there are some indications of when the market favours further trending vs a reversal.
Retracements usually occur on declining volume while reversals usually occur on increased volume, should the market retrace and volume is higher (than it was in the direction of the trend) this is a big red flag that momentum could be shifting.
Breaks of swing highs or swing lows
Uptrends are a series of higher highs and higher lows; downtrends are a series of lower lows and lower highs. When these significant swing points are breached this means that the trend has likely come to an end, uptrends would be a break of a higher low and downtrends a break of a lower high.
Swing level broken- NZDUSD Daily
Trendlines are used by many traders to determine the overall direction of the market so when a significant trendline is broken the market could be reversing.
Trendline break- EURAUD Daily
If one or more of these signs are present, it might be a good idea to wait for more price action to unfold or leave the trend alone for the time being.
Retracements form a major part of market structure and understanding them is a core aspect of trading. Now it’s all up to you to study the charts.
May the trend be with you