Basic Forex Trading Strategies – Part 1: Understanding Retracements And Reversals

The best forex trading strategies should always give the traders an objective means to analyze the market. For example, whenever there is a fall in the market, the dilemma of the trader is whether this drop will remain in the long term, or if it only has to be considered a momentary hiccup of the trend. It often happens that many traders close a position, just to see a new maximum after only few hours or days, depending on the type of trading. Such events are common, but if they happen very often they can be frustrating.
One way to cushion the effects of these wrong analysis, is to learn how to trade with retracements.

Retracements are temporary reversals of the main trend. The key factor of these reversals is that they are not lasting and therefore don’t represent a change in the main trend.
Here is an example of retracement. What can be noticed is that, in spite of these retracements, the long-term trend is always intact, with prices going down.
How can we distinguish a retracement from a real and long-term trend reversal?
The best way is to categorize these changes according to objective factors, leaving out emotions as much as possible.

This a list of factors we can observe in a trend at a given moment, with an indication of when this should be considered a retracement or a real reversal. This is an empiric yet very effective forex trading strategy.

Volume of exchanges
In retracements: volume is low, normally caused by small investors
In reversals: volume is high, caused by large investing institutions

Investment patterns
Ret: few investment patterns
Rev: many investment patterns

Time Frame
Ret: investment are made in the short-period
Rev: time frame goes towards the long period

Recent activities
Ret: normally after big losses or gains
Rev: any type of activity.

Candlestick chart
Ret: they don’t have a defined shape, typically with spinning tops (short body with long shadows on both sides)
Rev: typical reversal candlestick charts like those with engulfing lines

Having said that, one should be always aware that a tool supporting a forex strategy cannot change the market trend, therefore, there can always be false signals.
For example, something that ticks all the boxes of a retracement, may become a reversal without a warning. The best protection against this type of phenomena is using stop-loss orders.
For example, once a retracement is assumed, a stop-loss order can be placed immediately before the retracement level, or before the moving average supporting the trend (and not the reversal) on the long term.

Check out part 2 of Forex Trading Strategies and a few important tipis on how to choose a forex brokerage service or take advice from professionals.