Forex Mistake #39 – Retracements and Reversals

Why Retracements and Reversals could get you Broke?

The trend is your friend. Are you familiar with this saying? Well, if you are a Forex trader – even a new one – you probably heard it before. It is true that aligning your trades to the main trend will increase your chances of making money and hitting that elusive Take Profit level, but it is not always simple. Your job is not just to find a trend and place a trade in that direction; you have to also find a good entry point. That’s the tricky part and today I want to talk about avoiding a bad entry.

 

Retracements into Reversals – My World Got Upside Down

It is widely accepted that trading with the trend is easier than trading counter trend, just how swimming against the current is harder than going downstream. Ok enough with that; I will assume everyone in the world is trading in the direction of the main trend. The cleanest trades, the ones that go straight to your Take Profit are the ones taken after a retracement. As you already know, price moves in waves, mountains, valleys and these are called retracements. In a downtrend when price creates a mountain (meaning it goes up), we say it retraced. The same goes for a valley created in an uptrend. These retracements or pullbacks against the main trend are some of the best places to enter into a trend following trade. In other words, wait for the retracement whether you are in a downtrend or uptrend and then trade. Sounds simple? Yea, it is… most of the time. But sometimes that retracement will turn into a reversal, meaning that the main trend just decided to switch direction. Well sh1#e happens and you cannot always avoid it but you have to try at least. Since this is my main way of trading, I know a thing or two about retracements so let me share.

Once you’ve found a good, tradable trend, wait patiently for a move against it. But don’t be eager to enter just yet and instead wait until you can draw a trend line on that retracement. No trend line, no trade! Read that again please. If your trend is bearish, the retracement and the trend line will be bullish. If the trend is bullish, the retracement and the trend line will be bearish. I won’t go into the details of drawing trend lines for obvious reasons: you shouldn’t be trading if you cannot draw a simple trend line. The trade will be placed when your trend line is broken. If you have other entry triggers I’m not saying that you should replace them with my trend line, but at least take the trade when your indicator agrees and the trend line is broken. There’s more: use oscillators (RSI, Stochastic, etc.) and wait until they reach overbought (if you are in a downtrend) or oversold (if you are in an uptrend). Sure, if you wait until an oscillator reaches overbought or oversold you might miss some trades because price might start to move in the direction of the main trend sooner than expected. Well, tough luck! The market will be here tomorrow as well so don’t cry over a missed trade. If you really can’t wait until overbought/oversold territory is reached, at least wait until your oscillator goes above/below the 50 level. Come on that’s the least you can do. And here’s something else you can do: always check a higher time frame to see if the trend is still strong or if there are any signs of a reversal. These signs include but are not limited to: regular divergence, overbought oscillators in an uptrend, oversold oscillators in a downtrend, lower highs or double tops in an uptrend and higher lows or double bottoms in a downtrend. Uh, is that a lot to remember? Maybe, but it’s not all: don’t forget about Support and Resistance, about news, about… a lot of things. I cannot mention them all and if you think it’s too complicated, stick to the basics: draw a trend line and wait for it to be broken before trading.

 

Bottom Line – The Bitter Truth Is Not So Bitter After All

Believe me, I am not a pessimist when I say that you won’t be able to avoid all retracements that turn into full scale reversals. But that doesn’t mean you won’t make money. By using the things I wrote above, you will get better trades and you will avoid more reversals than otherwise. It’s not the secret to Forex success but it is part of becoming a better trader and not going broke. The secret to Forex is trading with at least 1:1 risk to reward ratio… or is it? I’m not sure yet so I’ll get back to you on that.

 

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