Consider the following scenario. The price begins to soar. Continues to rise. Then it starts to rain.
And still plummeting.
And still plummeting.
Then it begins to rise again!
Have you ever been in a scenario like this before?
Price activity appears to be rallying, indicating that a buy trade is in order.
In the preceding example, the forex trader failed to distinguish between a retracement and a reversal.
Instead of being patient and riding the broader downtrend, the trader anticipated a reversal and entered a long position. Oh no, his money has vanished!
See how Happy Pip was taken in by the “Smooth Retracement” in one of her AUD/USD trades.
You will discover the features of retracements and reversals, how to spot them, and how to protect yourself from false signals in this session.
What are Trend Retracements?
A retracement is described as a transient price movement in the opposite direction of the established trend.
Another way to look at it is as a price movement area that moves against the trend but then returns to the trend.
What are Trend Reversals?
Reversals are defined as a change in the overall trend of price.
When an uptrend switches to a downtrend, a reversal occurs.
When a downtrend switches to an uptrend, a reversal also occurs.
Using the same example as above, here’s how a reversal looks like.
What Should You Do?
When faced with a possible retracement or reversal, you have three options:
1. If in a position you could hold onto your position. This could lead to losses if the retracement turns out to be a longer-term reversal.
2. You could close your position and re-enter if the price starts moving with the overall trend again. Of course, there could be a missed trade opportunity if the price sharply moves in one direction. Money is also wasted on spreads if you decide to re-enter.
3. You could close permanently. This could result in a loss (if the price went against you) or a huge profit (if you closed at a top or bottom) depending on the structure of your trade and what happens after.
Because reversals can occur at any time, determining the optimal decision is not always simple.
This is why, while trading with the trend, employing trailing stop loss points can be an excellent risk management approach.
You can use it to protect your winnings and ensure that you always walk away with some pips if a long-term reversal occurs.