Forex Trading Tip: How to Use Retracements to Your Advantage

Forex Trading Tip: How to Use Retracements to Your Advantage

Retracements are a necessary evil. They are a market’s mechanism to shake out weak longs or shorts when positions get too over extended on one side or the other.’

See why retracements are important

As noted in Why Retracements Work and How to Use Them in Your Trading,

Let’s say we are in a trend. The market gets overbought or oversold. It needs a shakeout. By shakeout I mean the market needs to squeeze out the weak hands, the weak shorts or weak longs before it can go after a new high or low….

…the currency (or any market) needs to do now is make a new retracement low or high (as the case may be) before buyers/sellers come in and resume the trend.

The point here is when you have a retracement and it stalls, beware of the move back in the direction of the overall trend as the market has less ability to absorb the flows than before the market corrected.

Forex Trading Tip: How to Use Retracements to Your Advantage

Textbook case: EURUSD Retracement

As this chart shows, it was a textbook case in the EURUSD, which plunged to a 1.0682 low after the U.S. election results. It then retraced sharply to 1.0833 but did not go far enough to break the downtrend. It then reversed in favor of the trend to break to a new low.

The key takeaway is when in a mature trend or one that has moved too far, too fast a retracement is necessary to setup a move to a new low or high. Keep this in mind when trading in a trend. View a retracement as a necessary evil that is needed before a trend can resume. BUT don’t ignore what charts are saying when a market retraces.

In this regard , keep an eye on longer term technical levels that would either keep the current trend intact or break a level that would change the technical picture. Following this logic will allow you to take advantage of retracements rather than letting them take advantage of you.

Addendum: November 13, 2024

To further prove the logic of what I discussed, See the following chart where a mini retracement that took out stops and weak short EURUSD positions was followed by a move down to a new low.

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Forex Trading Tip: How to Use Retracements to Your Advantage

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