Establishing what retracements or pullbacks are:
There are a lot of trading styles out there and today I will go into the details of one of the most widely known styles or strategy if you wish. This is trading by timing retracements or pullbacks. These two different words are sort of synonymous in the lingua of Forex trading so I will be using them interchangeably in this lesson. Retracements or pullbacks are dependent on mean reversion.
Mean reversion in trading signifies that the market doesn’t move in a straight line. The concept of mean reversion shows that a market will retrace some of the main moves before trending in its respective direction.
In an uptrend, there will be relatively little down moves against the trend before the main trend up continues. The opposite is true for a downtrend. The moves against the main trend is mean reversion in action.
There are many ways traders can time retracements or pullbacks for better setups and optimal entries. In this lesson I am going to show you some common and uncommon ways in scanning for pullbacks to your advantage.
In expectation of benefiting from retracements, look towards diagonal levels, horizontal levels, breaks & retests and pivot levels. A deep and applied knowledge of candlesticks (reversal candlesticks) is needed to trade pullbacks.
As mainstream as they may sound, diagonal levels come in the form of simple trendlines and channels. Some traders eradicate diagonal levels totally from their trading and I’m afraid they might be missing out on a lot of action. Some of the best trades I’ve taken were timed by diagonal levels.
Trendlines are established when two or three highs or lows of a trend can be connected. For hard rules, a trendline is not confirmed until there’s a third touch of a trendline.
Channels are established when three or more highs and lows of a trend can be connected in a manner that, the lines which act as support and resistance are able to contain the chart.
When these diagonal levels are fully formed, we get to trade the pullback idea by waiting for the next touch of the line together with candlestick reaction on the level.
Pullbacks are also known as Corrective waves and moves of the main trend are known as Impulsive waves.
In this daily chart of the EURUSD, the market had been in a downtrend since mid-June – October of 2019. This trend down demanded a trendline ; the blue boxes mark the pullbacks against the main trend down. The market retraced 4 times before before the final move against the trend resulted in a break(red box). The black candlesticks represent the main moves of the downtrend.
This is a daily chart of Crude Oil which is in an uptrend. Since the highs and lows can be connected, that market has presented an ascending channel. The red boxes are the retracement moves against the main trend up. Just like above, there were 4 pullbacks before a final break occurred on 5th time the market attempted testing the support of the channel (blue box).
Horizontal levels are none other than the traditional support and resistance levels which are the basis of price action. Support and resistance levels are broken all the time since the market can not trade in a range forever.
When a support level is broken, the broken level becomes the newest resistance. When a resistance level is broken, the breached level becomes the newest support. This concept is known as support turned resistance or resistance turned support. That is, corrective moves to the broken level for the market to rise or fall again.
When price breaks these levels, there are aggressive traders who dive right in to benefit from the impulse; and there are those traders who wait for a retracement back to the level that was formerly breached.
In order to trade support turned resistance or resistance turned support; you need to pay attention to how candlestick(s) will react at the newest levels upon retracements or pullbacks.
On this CADJPY daily chart, the market broke support level aggressively in July 2019. Afterwards it went through some choppiness and moved up aggressively back to the former support level to test it as new resistance (red arrow) in September 2019. The red box represents the retracement.
The reverse of the above occurred on the daily chart of the NZDUSD. This pair held as strong resistance as it held the price for about 3 times between September and early October 2019. It broke resistance mid-October and tested the new support twice before the impulsive wave set in.
Breaks and retests.
The section right above can be classified as breaks and retest for horizontal levels. Breaks and retests occur on diagonal levels too. Since markets do not trend up or down forever, trends break too. Uptrends turn to downtrends and vice versa.
When trends break, you can jump right in or you can wait for a potential retest. Lets us look at examples of some trends that broke and retested.
This uptrend on the NZDUSD broke the trendline and retested it as new support for a trend change to occur(Blue rectangle).
The downtrend on the EURUSD broke eventually; the resistance of the channel was retested as new support and the bulls took over for a while.
The whole point of waiting for retracements or pullbacks.
When any market moves a great amount of pips in a specific direction, it would make no risk management sense to dive right in. If you dive right in you put yourself in a low probability trade and perhaps one that would require a wide stop loss.
In timing pullbacks with diagonals, it is always prudent to wait for a corrective move to the line of interest before forming a bias with candlestick prompts.
On horizontal levels, it is also prudent to wait for pullbacks to the levels if you miss the initial impulsive or breakout move.
On the flip side, there are run away markets. Those ones do little or no corrective moves so pullbacks don’t always happen. Knowing that as a fact, your patience is what would matter the most in times like those.
Retracement or pullbacks with Pivot levels.
Many traders haven’t exploited pivot levels which are a goldmine in my opinion. Price respect pivot levels and much as it respects Fibonacci levels. Pivot levels are based on price and time and they show various hidden support and resistance levels over a period.
The focus is not on all the various levels that can be generated by pivots but on one. I consider this one the most important pivot level. It is the 50% Fibonacci level whose time focus is on the daily, weekly, monthly or even the yearly.
As I stated in the second paragraph; “the market doesn’t move in a straight line. The market pulls back to a single most important level some of the time before continuing its main move. In order to capture this pivot level, your timeframe matters a lot.
The pivot level is obtained by capturing the highest and lowest price of a period whilst marking the midpoint. Read the extensive lesson on period separators to learn how to generate this pivot level. Continue here ==> https://wp.me/patuXq-YQ