Trending Markets and Retracements ~ trading system forex elite section
Identifying A Trending Market
So what do we mean by a trend? Its an extremely simple and important point, but one often forgotten: a down trending market creates consecutively lower lows and lower highs over time. Conversely, an up trending market creates consecutively higher highs and higher lows over time. So what we want to look for, before we even bother with indicators like Moving Averages, is Swing Points in succession that satisfy this relationship, as illustrated below.
Another way to identify trending markets without any technical indicators is to look for those legs in price action that have an almost linear look to them. That is, those that move decisively with little interruption, and covering a relatively large amount of ground in a short period of time. When a sequence of lower lows and highs, or higher highs and lows, are strung together, it is likely that the market is trending.
Candlesticks can also be used to enhance the identification of trending markets. For instance, there are more down closes in a downtrend (red), and more up closes in an uptrend (green), as shown in the chart below.
Identifying Retracements
The term retracement (or sometimes referred to as a correction or pullback) generally refers to any type of counter-trend price action that interrupts the broader flow of the market for a defined period of time without reversing it on the degree of trend in which it is encountered. Put simply, we are looking for instances of where the market is moving in the wrong direction relative to a trend, recovering a portion of the preceding impulsive movement, but without exceeding its startiog point.
The simple and practical way to explain why the market behaves this way is that at critical support and resistance levels, some portion of the market is taking profit. For example, as numerous traders cover shorts in a downtrend (effectively going long) at or near a confluence of support targets, selling pressure will disappear for a period of time before the market consolidation process is complete allowing for a return to trend. The traders who were more bearish than those covering their short positions sell into the buying, and away we go again.
Unlike the trend of the market, retracements have a very different appearance. In addition to recovering only a portion of the preceding impulsive movement, they often feature a lot of overlap in terms of the smaller waves comprising them, and often (but not always) unfold in sequences of threes. The important point is that without having a method of identifying these patterns, a lot of traders will be in despair at all the supposedly random noise and compressed volatility theyre seeing, hoping a trending market will return, but having no idea when.
The following diagram illustrates a typical contrast between these two varieties of price action, which we can call impulsive (the often linear looking sequences aligned with trend) and corrective (the three-wave overlapping sequences which temporarily interrupt the trend). The downtrend is reflected in the relatively smooth and brisk movement of the down leg to the left. By contrast, we can see the strained, overlapping progress of price action once a temporary bottom is made (at a price level that represents one of those confluences of support mentioned above).
In this example, we have plotted a Fibonacci retracement level which shows that at the point where the three larger subdivisions of the correction are finished (at the dashed horizontal line), the whole sequence has retraced - to a precise degree of accuracy - the Golden Mean ratio of 61.8%, a fairly standard proportion for Fibonacci retracements.
Putting It Together
So how do these two concepts - trending markets and retracements - combine? To put it simply, it is at the expected point of termination of a retracement where were looking to jump into the market in the direction of a trend at higher degree. So a retracement slanted in the sideways-to-up direction against a valid downtrend is the rally were looking to sell. Conversely, a retracement slanted in the sideways-to-down direction against a valid uptrend is the dip were looking to buy.
We dont have to worry that on the hourly chart, for example, the retracement doesnt have the same look as the illustration above - often, pullbacks are briefer and simpler in construction, particularly in a fast-moving market. The key is that were keeping the trend in mind, looking to trade only in that direction, and focusing our attention on finding a confluence of support or resistance that strongly suggests the end-point of the retracement.
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