4 simple rules to master price retracement for forex trading

Retracement is an important pillar of price action

The key to buy low sell high or sell high buy low is all about identifying retracement moves and entering at a good retracement level. It is such an important concept and is a key pillar of our Forex Tflow® Currency Trading course.

We have written quite a number of postings about retracements and recently an important phenomenon actually happened in the regional stock markets. I wrote about it here a story on Nikkei 225, Hang Seng Index and Straits Times Index meeting critical retracement levels.

Nikkei225 monthly chart 2005-2013

Regional stock indices like Nikkei 225 met an important Fib Retracement level

The fact is price retracement is such an important market phenomenon/resource to master to make more money in the market.


4 simple rules to understand price retracement

Never mind about the Fibonacci levels. Today lets just talk about retracement only. I am going to use 3 simple pictures with some rules to demonstrate.

Price retracement

Retracement is counter-trend and can go as low as starting line


Imagine price moves from starting line X to Point 1 above. Imagine that we have established that X -> 1 is the trend i.e. up. When price comes down, any point that price stops in the green zone is retracement.

Rule #1 – Retracement is a counter-trend move.

Rule #2 – Price that retraces back to starting line but does not cross is still a retracement.

Retracement happens in the market because bulls who were long took profit at high. Bears who were selling counter-trend pushed price down. Retracement happens in the market all the time. Because it always happens, the best time for buyers is to buy during a retracement because price gets lower or cheaper.

Price continuation

Retracement ends – continuation takes over

Rule #3 – Price continues in direction of trend when retracement is over.

And hence the saying ‘buy low sell high’. A continuation will move in the direction of Point 1 and can extend beyond it.


What is no longer retracement?

What if price retraces beyond the starting line? Can price retracement tell me whether price trend has changed?


Rule #4 – Price retracement anywhere beyond the starting line starts a new trend.

Price retracing beyond the starting line is no longer retracement. It becomes a reversal. All the buyers between X -> 1 lost money while sellers were able to push price lower. The new trend is down and buying becomes counter-trend trade. The right thing to do now is to wait for price to retrace in order to sell high buy low.

Price reversal

Going beyond starting line starts new trend – retracement became reversal

More retracement tips for sophisticated traders

  1. Retracement usually returns price to fibonacci retracement levels.
  2. Traders should not attempt to ‘fish’ for price at retracement levels. The best move is to wait for price action to confirm that a fib level is valid before entering.
  3. Retracement back to X (100% retracement) can sometimes overshoot as part of stop-hunting, volatility and many other reasons. Traders must separate when it is overshooting and when it is a reversal like Rule #4.
  4. Retracement moves can become subtrend inside lower time frames. Over-inspecting multiple time frames can result in confusion but higher time frames are always more critical.
  5. With-the-trend trades that exploit price retracement to make price cheaper to buy is a smarter way to trade than to buy-higher-hoping-to-sell-higher type of breakout trade.
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