Various trading strategies for forex traders, the retracement trading strategy is one of them. The purpose of all trading strategies is the same, in their efforts to seize opportunities in the market for profit.
A brief look at the retracement trading strategy, this is trading with the idea that prices never move in a perfectly straight line. Where the price will make a kind of pause in the middle of a bigger trend. Traders will wait for the price to retrace before continuing the main trend.
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What is retracement in trading?
According to Investopedia, retracement is a technical analysis in which traders analyze the market to identify minor pullbacks. Or on the other hand changes in the direction of the main trend in financial markets, whether in the stock market, or indices, forex, or cryptocurrencies.
A retracement is a temporary reversal in a financial market instrument, and this idea is different from a reversal in a long-term price trend. Retracement is a reversal pattern in the short term.
Before continuing the main trend, the market tends to be a pullback which is a reversal wave in the short term before continuing the main trend.
How do you identify a retracement?
For traders, identifying retracements is an important point to minimize trading risk.
As we already know, the definition of a retracement is a temporary pullback or temporary reversal. It is important to understand the difference between a retracement and a reversal.
But before continuing to that point, here we will only try to provide a summary, of how to identify the retracement.
There are several methods that can be used to identify retracements. It’s not completely accurate, considering the dynamic forex market, it can’t be calculated like math.
Using Fibonacci retracement
This is the first method, using Fibonacci retracement. You may recognize this is an indicator, but actually, it is included in the list of objects. By taking advantage of the Fibonacci levels of 23.6, 38.2, and 50, traders can predict by focusing on price behavior at these levels.
Some opinions say the best level for retracement is the 50 Fibonacci level. But again that the forex market is not math.
Using Pivot point
This is another method for identifying retracements. Through calculations with certain formulas, Pivot Points can produce levels of R1, R2, and R3, then S1, S2, and S3. In this case, R means Resistance, and S is Support.
In a downtrend market, traders wait for the price to return to the R1, R2, or R3 levels and monitor whether it is a breakout or rejection. If the breakout is possible the price will reverse.
Meanwhile, in an uptrend market, traders wait for prices to reach the S1, S2, and S3 levels whether it is a rejection or a break if the breakout is likely to be a reversal. The Pivot Point indicator is not available by default in MT4, traders need to manually install it.
Using Trendline
This becomes the third method for identifying retracements. Using a trendline is the easiest method than the previous two methods.
In a downtrend market, traders draw trend lines starting from high to high. This will form a trend line with a downward slope. Focus on when the price approaches the trend line. Whether at that line it will be rejection or a breakout. If the breakout is likely a reversal.
On the other hand, during an uptrend, draw a trend line starting from low to low. In an Uptrend market, the market usually forms a higher low than the previous low. So by drawing a trend line, it will form a trend line with an upward slope.
What is the difference between pullback and retracement?
Although they look similar, retracements and reversals are very different. Both have different characteristics.
- A retracement is a short-term reversal, a reversal is a long-term trend change.
- Retracements often occur during large price movements, reversals can occur at any time.
- Retracements are not influenced by fundamental news, the macroeconomic environment does not change, reversals are influenced by fundamentals, and the macroeconomic environment can change.
- The retracement, in the uptrend, allows the price to rally higher, in the downtrend it allows the price to decline further. In reversal, in an uptrend a little selling interest cannot force prices to fall, in a downtrend, a little buying interest cannot force prices to rise.
- Retracement, no shift in short interest. Reversal, rising short interest.
- Retracements, often form Indecisive candles with typical long tops and bottoms (spinning tops). Reversal candles – including engulfing, soldiers, and other similar patterns
Why do pullbacks happen?
A pullback tendency occurs when a price trend experiences a large price movement. At that time some traders took profits on their previous positions, resulting in a pullback. This can be an opportunity to gain further profits if the fundamentals still support the continuation of the trend.
A pullback tells the trader there is a temporary reversal to a technical area such as a Fibonacci level, Pivot point Trendline, or MA line before its main trend resumes.
How do you profit from trading pullbacks?
Pullbacks provide opportunities for lower risk and have higher potential gains. In an uptrend market, traders wait for a pullback opportunity before deciding to open a long position. On the other hand, in a downtrend market, traders wait for a pullback opportunity before opening short positions.
In an effort to profit from pullbacks, traders use different methods, such as using Fibonacci, Pivot points, trendlines, etc. Broadly speaking, here are the steps to take advantage of a pullback.
- Identify the main trend or major trend. This is an important point to wait for a pullback opportunity.
- Using a lower timeframe to wait for a pullback, for example with H1.
- Choose the method that will be used to wait for the pullback. Maybe you choose the Fibonacci, trendline, or pivot point. Depending on your method, the pullback price area may be different for each method. For example in Fibonacci, the focus is on the 38.2 and 50 levels as pullback areas.
- Place a stop loss below the pullback price level in an uptrend market and above the pullback level in a downtrend market. Set the target when the market forms a new high in an uptrend and a new low in a downtrend.
Are pullbacks profitable?
Theoretically, the retracement trading strategy is the most profitable. And it often happens in trending markets. There will be a retracement or pullback before continuing its main trend. The trend-following strategy is considered the best for gaining profits.
But that doesn’t mean the retracement trading strategy doesn’t have weaknesses. In this case, there may be a trader who faces a mistake in determining whether it is a retracement or a reversal.
Are correction and retracement the same?
Often in market analysis, an analyst writes about price corrections, retracements, consolidations, or pullbacks. All these terms are essentially the same thing.
The difference in using terms is mostly due to the tendency of analysts to use certain terms. In an analysis using the Fibonacci method, more analysts use retracements. While analysts with the trendline method, more traders choose the term pullback. Or analysts who read price action are more inclined to choose the term correction.
So there is no need to be confused with all these terms because they refer to the same condition.
How long does a retracement last?
There is no specific time the pullback will last long, it also depends on the volume of transactions on the asset. On the stock market, the probability of a pullback lasting between one month for a 5-10% decline in assets. Meanwhile, a 10%-20% reduction will take approximately four months.
In the forex market, when there is a large price movement, pullbacks often occur on a shorter timeframe as profit-taking. But in the long term, the retracement can occur at swing highs or swing lows on the H1 time frame on several trading days.
How do you know if a trend is reversing?
How to know the market will reverse is easier said but not easy to do. Reversing occurs when the price changes direction, either from an uptrend and then forms a downtrend pattern or vice versa from a downtrend to an uptrend.
Here the trader focuses more on the price area where there will be resistance. Using the trendline method, here the trader will focus on the price when it approaches the trend line. Understanding candle patterns are also important in predicting a trend that will experience reversing.
Theoretically, when the price has a retracement pattern, it will be marked by the formation of a reversal candlestick pattern.
However, if in the price area it seems that the demand volume is still high, it is possible that there will be a breakout and a reversal pattern.
The reversal pattern in stocks is quite different from forex in that the higher price volatility in the forex market makes it more difficult to understand when it will be a reversal or just a retracement.
How to use retracement in trading?
The most common method for retracement trading strategies is to use Fibonacci retracements. This trading tool created by Leonardo Fibonacci is most widely used by traders to find retracement points through the Fibonacci golden ratio.
Here we do not delve deeper into the history of the creation of the Fibonacci golden ratio, but rather emphasize how to use this tool for retracement trading strategies.
In using retracements, the focus of traders is to pay attention to the Fibonacci levels, especially the 50 and 38.2 levels, although the possibility of a retracement can occur at the 23.6 level, too much focus on the retracement levels can reduce the accuracy of the retracement analysis.
Why do traders need to only focus on these two retracement levels, the goal is to find retracement trade entries of good quality.
Fibonacci retracement trading strategy
At an advanced level, the retracement trading strategy is how to spot Fibonacci retracements in an effort to find the best retracement for entry points.
The basic thing that traders need to remember is that a retracement is different from a reversal, which occurs in a large market direction, there will be a pullback before there is a continuation of the trend.
How to draw Fibonacci retracement
How to draw Fibonacci is very easy, depending on the market uptrend or downtrend the way to drag the start of the line is different.
Uptrend market
- Identity trend market, by looking at the direction.
- Find the swing low to start the Fibonacci retracement point, drag it to the right and find the swing high as the Fibonacci endpoint.
- Focus on the 38.2 and 50 Fibo levels as retracement points. Aggressive traders may use 23.6 level retracement.
- Pay attention to the candle pattern when the price is at that level as a confirmation signal.
Downtrend market
- Identity downtrend market, by looking at the direction.
- Find the swing high to start the Fibonacci retracement point, drag it to the right and find the swing low as the Fibonacci endpoint.
- Focus on the 38.2 and 50 Fibo levels as retracement points. There are aggressive traders who may use 23.6 level retracement.
- Pay attention to the candle pattern when the price is at that level as a confirmation signal, by looking reversal candle.
What is a healthy retracement?
Healthy Retracements are temporary reversal patterns that commonly occur as impulse waves between 23% and 78%. This is the retracement distance starting from the price point of the measured asset.
Fibonacci retracement trading rules
The rules of retracement trading with Fibonacci are different from the golden rules of Fibonacci itself. If in Fibonacci the golden ratio is 1.618, it is also called “divine proportion,”.
The rules of retracement trading with Fibonacci are:
- Only use retracements in strong trends.
- Focus on the Fibonacci 38.2 and 50.0 levels as the best possible reversal points.
- Recognize reversal candlestick patterns, such as hammer, hanging man, etc.
- Keep using stop loss, because the market is very dynamic.
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Final thought
For traders who already have long experience but have not found a suitable trading strategy. Maybe this Retracement trading strategy is interesting enough to learn and try.
But it’s also good to study fundamental analysis, where in theory, the impact of fundamentals is long term. With a combination of technical retracement trading strategies, it may provide good profit potential.
But keep in mind that the forex market is very dynamic, and leverage in CFD trading increases the risk even though it can boost the profit.
Note: this article is for information only and is not investment advice or solicitation. Forex, crypto CFD is a risky trade. Each investor is responsible for their investment.
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