Many traders have difficulties discerning a pullback from a reversal. Nowadays, with momentum-seeking algos pushing prices further than even experienced traders would expect, being able to understand when a pullback is still valid (and entries in line with the trend are valid) and when a pullback has instead started to transition into a reversal (when entries are no longer admissible because it’s better to wait for further information) is of vital importance.
What is a Retracement?
First and foremost, retracements can only exist if the market is in a trending motion. I would strongly suggest reviewing this article for a foundation in identifying a trending market. In essence, an uptrend is represented by a series of higher high/higher low “stair steps”; a downtrend is represented by a series of lower high/lower low steps. In the chart below, we have highlighted higher highs & higher lows in blue, and lower highs & lower lows in red. Also, a lower low in an uptrend and a higher high in a downtrend (which signal a lack of trend strength) are marked in black.
We need the market to push through prior highs (in an up trend) or prior lows (in a downtrend) as marked on our trend identification time frame (in this case the Daily chart). Failure to do so would be a sign of weakness and we would start expecting a retracement. We would, in any case, want the most recent swing point (on the daily chart) to not be violated on the retracement, in order to still have faith in the trend.
So retracements, technically speaking, are nothing more than periods where the market, for whatever reason, runs out of gas and starts to generate a counter-trend movement in the form of either as consolidations or temporary reversals on your smaller time frames. So, all that is required is to pay attention to these smaller time frames, until they align themselves with the primary time frame once more. This is the concept of self-similarity.
When Do Retracements End?
In the chart below we have zoomed into the 4H chart of AudNzd and have simply drawn a trendline connecting the momentum highs of the pullback motion in the daily uptrend. Remember: as long as the prior swing lows are not violated, all we need is for the market to push in line with the trend again, hence exiting/ending the counter-trend move.
The downward leg was a bit more complex because we had two instances when the market pulled back so hard that it threatened the downtrend (black lines). In these cases it might be better to not look for entries immediately upon exit of the counter-trend move, and instead wait until the market gives a little push in the right direction first.
On May 23rd, for example, AudNzd had reappeared on my watchlist (see chart below) and on that of some coaching students as we had exited the counter-trend move and were pushing below the higher daily swing low. In the chart below you can also see some short-term retracements on the hourly chart which are excellent value propositions.
Another Example: Sugar
Sugar gave us a textbook example recently. In the month of May, Sugar started a counter-trend move with 2 complex components:
- a higher low (blue)
- pressure on the prior swing high (red box)
So once again this is a case where it’s better to wait for the market to give a little “push” in line with the trend, before attempting to jump aboard again.
On May 26th, the short entry was ripe and had higher odds of working because momentum was back in line with the overall trend.
Over to You
- a viable retracement is a counter-trend move that does not violate the prior swing low (in an uptrend) or high (in a downtrend). The counter-trend move will be more visible (and perhaps more easily exploitable) on the timeframes that are lower than your primary timeframe.
- When does a retracement move end? Logically, when the lower timeframes start to trend in the direction of the higher timeframe once more.
- When does a retracement turn into a reversal? Logically, when the move violates the prior swing levels on the trend identification timeframe (the black lines in our AudNzd chart were alerts of such a behaviour, but had no followthrough).
It will take some experimentation on your part to get comfortable identifying & playing retracement entries. and of course if you need further guidance on this, jump into our Trading Tribe Chatroom and we’ll discuss it!
About the Author
Justin Paolini is a Forex trader & Coach. He is a member of the team at www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.