How to Trade Retracements | FXTRADING.com - International

How to Trade Retracements

Admin, September 3rd, 2020

“Buying the dip” or “selling the rally” is a method to trade a retracement. In this article we explore methods to identify such opportunities.

Pullbacks, corrections, retracements and countertrend moves are all the same thing; a movement against the dominant trend. And if a retracement is properly identified alongside a trend, it can create a tradeable opportunity.

A key ingredient to help locate a pullback worth trading is to identify a strong trend. If you have not already done so, please refer to our trend guide, as it is highly relevant for this style of trading.

By trading pullbacks, a trader is in effect a trend trader. They seek to enter a trade in line with the dominant trend but enter during a corrective phase, hoping to gain a “better price” than if they were to wait for a break of the next cycle high or low.

Yet at the same time, trading a pullback is also a form of mean reversion, as they are assuming prices will revert to the mean and then continue to trend.

 

Measuring Markets to Assess Quality

Whilst trend analysis can be performed by simply visualising a chart, it can help to take a methodical approach and use tools to measure the strength of the retracement and trend. In doing so the trader hopes to filter out higher quality trades.

If you are in the lucky situation where you have more pullbacks to choose from than you’d like to trade, then it can be useful to compare them on a relative basis.

Two approaches to achieve this include:

  1. Compare trend strength
  2. Compare retracement depth

Compare Trend Strength
A stronger trend is generally assumed to provide shallow retracements before continuing the trend. It then makes sense to compare several markets in percentage terms to filter out the strong versus the weak.

In this example, the New Zealand dollar has moved higher across the board and a trader is seeking to enter on an intraday retracement. From this information we can see that NZD/USD and NZD/CHF are the strongest pairs, which make them of interest to trade a potential retracement. Moreover, NZD/USD has already begun to retrace, so the trader pulls up their NZD/USD chart for further analysis.

There are a few options available to access such information:

  • Indicators are available from the MQL5 hub and via MT4 forums which will show relative strength on an MT4 chart. Some will be free whilst others will be a paid service.
  • If you’re comfortable with excel or a calculator, you can simply calculate the percentage change from trough to peak (for an uptrend) or peak to trough (for a downtrend) to directly compare trend strength.
  • Alternatively, use a website which allows you to view a market snapshot of performance returns, or build a watchlist to monitor performance. This way you can quickly compare returns over daily, weekly or monthly timeframes to rank your chosen markets.

Compare Retracement Depths
Another approach is to measure the percentage of the retracement itself, with the assumption that a shallower retracement is indicative of a stronger underlying trend and its potential to continue with that trend.

For example, a trader could compare the retracements of the S&P 500 and the DJIA (Dow Jones Industrial Average) from their highs, over a similar period.

In percentage terms, the Dow retraced -1.65% from its highs whilst the S&P 500 retraced just -1.14%. A trader could then assume that the S&P 500 weathered the storm better and is more likely to break to new highs if sentiment improves. That it also trades just off its all-time high is also appealing about the S&P 500. They could then favour bullish setups on the S&P 500 over DJIA.

Note: Whilst the MT4 crosshair allows you to measure moves in pips by holding the Ctrl key, it is not useful to directly compare instruments as they each use different pip or point values. However, a simple % calculation should suffice.

To calculate % retracements in a spreadsheet:

  • Retracement within an uptrend: % = (Trough – peak) / peak x 100
  • Retracement within a downtrend: % = (Peak – trough) trough x 100

 

Identify Potential Levels of Support to Find the End of Retracements

A retracement coupled with a support or resistance level can provide is a simple yet powerful strategy. Please refer to our in-depth guide on support and resistance levels as they are relevant for this section.

Fibonacci retracement levels are in some ways a quantitative tool as they allow you to measure a pullback relative to its prior movement. It is then useful to measure strong retracements such as 23.6% and 38.2% and favour shallow Fibonacci retracements.

By default, MT4 will provide the levels 38.2%, 50% and 61.8% (even though 50% is not an actual Fibonacci number). But by double clicking on the tool you can add your own levels.

A pullback into a moving average is also a popular way to identify potential retracement trades. If shorter-term average such as the 5 or 10 period hold as support or resistance, it suggests near-term momentum is stronger than if it finds support at longer-term averages like the 50 or 100-period.

 

Use a Time Filter to Identify Potential Retracements:

For minor retracements against strong trends, traders can use a sequence of bullish or bearish closes against the trend to be alert for the end of a correction. Whilst this is a popular component for trading system design, ‘consecutive bar counts’ are also useful to a discretionary trader.

Taking daily data for NZD/USD between 1982 – 2018, we can see the probability of three bearish days is around 6%. Therefore, the probability of bar 4 being bullish is around 94%. We can clearly see that, like flipping a coin, the probably of a longer consecutive sequence drops exponentially the longer the sequence.

Put simply, the probability of a candle breaking the sequence increases, as the sequence gets longer.

Of course, the downside to this statistic is it does not guarantee an actual reversal. It merely suggests the next bar is likely to be in the opposite direction to the sequence. But if this is combined with some of the suggestions above, the trader has an interesting and mechanical approach to add to their discretionary trading.


Combining Methods to Identify the End of a Pullback

Using a recent example of the Nasdaq 100, we have layered together three of these techniques to help identify the end of a correction.

The Nasdaq 100 is within an established uptrend the 20-period eMA is providing dynamic support. After a break to a new high, three bearish candles formed and retraced lower. The third candle formed a bullish hammer and almost perfectly respected the 38.2% Fibonacci retracement level to warn the pullback may be nearing its end. The next candle saw a clear break to a new high and the trend continued.

Methods to Trade a Retracement

Once a trend and its retracement has been identified, the entry method then needs to be selected. We will assume you are familiar with entry methods within MT4. If not, please refer to our guides on Order Types within MT4 for an understanding of how they work and when to use them.

Entering Using a Break of the Prior Candle High / Low
Using the prior example of a 3-bar pullback into support, a trader could have used a buy-stop order above the high of the third candle when it had closed. This way, a break above the candle triggers the trade with a ‘set and forget’ approach.

Of course, the trader can still be stopped out, which is why a protective stop would have been placed to help minimise any losses to the trader.

However, if the fourth bar were instead to trade lower and not trigger the trade, the trader can either decide whether to cancel the order, or place a new order above the high of the fourth bar once that bar had closed.

Entering Following a Break of Trendline / Retracement line
In this example the DJI (US30) was in an established uptrend before price action entered a multi-week retracement. However, the correction failed to test the 38.2% Fibonacci level (a sign of strength) and then printed a higher low in form of a bullish hammer to warn of a change in trend. The hammer also closed back above the 50-day eMA and just beneath the retracement line to warn of a possible breakout.

  • A trader could have considered entering long after the retracement line was broken using a buy-stop pending order.
  • Alternatively, they could have waited for a candle (or series of candles) to close above the retracement line for extra confirmation, before entering live at market.
  • A third option (which would have resulted in a missed trade), was to wait for a retracement towards the broken trendline.
  • A fourth option would have been to wait for a break above the prior cycle high to confirm a change in trend.

Entering During a Consolidation
To enter during a consolidation is effectively like trading a breakout before prices have broken a key level. However, the theory here is that volatility fluctuates between levels of low and high volatility. So, if a trend has been established and prices retrace and consolidate, the eventual breakout is more likely to be in line with the dominant trend. At least, in theory…

In this example, USD/SGD was within an established downtrend before breaking key support levels with strong momentum. After drifting higher, prices consolidated just off-of the lows. At this point it was a shallow retracement relative to a strong down move, so a trader could consider entering during the consolidation phase.

  • If the trader felt confident that prices could break lower, they could have entered short ‘live at market’ with a stop above the consolidation, or above the pivotal resistance zone.
  • Alternatively, they could have entered a short sell-stop beneath the consolidation to ‘catch’ the breakout if it moved lower.
  • In this example, momentum initially broke out of consolidation in line with the bearish trend. Yet the move was short-lived as momentum then reversed to key resistance.

 

Reward to risk needs to be Considered

On a final note, the reward to risk potential should always be in the mind of the trader when selecting a trade. And this can be particularly true if entering during a retracement as levels or support or resistance could be nearby which may diminish profit potential.

For example, the strong trend and minor pullback on GBP/CHF initially looks appealing.

  • Bullish momentum broke it convincingly out of a sideways range.
  • A shallow pullback has produced a bullish hammer near the 10 and 20-period MA’s.
  • A clear retracement line can be seen.

However, the R:R (reward to risk) appears undesirable given there are historical levels of resistance nearby. Assuming the trader were to place their stop beneath the recent low, the initial R:R it is less than 1:1 just to get to the cycle high. And the same can be said if using a single bar pattern such as an engulfing candle to enter. If the candle is too large at the swing point it may mean the stop is too far relative to the target, which will reduce the reward to risk potential.

But, assuming not too many technical levels obscure the potential for a breakout, trading a pullback can become a relatively simple strategy which can work across multiple timeframes and markets.

 

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