An Intern Learns – Retracement and Reversals
So by now you should have a fairly good understanding of the tools of both fundamental and technical analyses. These are your Batman and Robin of trading; you need both to make a win! However even with all this knowledge you still need to know how to read the patterns on the charts. There is still more to learn unfortunately! I’ve been poring over the charts, looking at patterns and continuing my research on how to make a winning trade. Still in demo mode on my MahiFX account, I’m getting more confident, and slowly getting better at trading!
Today I’m going to look at trend spotting. Now although it may be easy to tell when everyone is wearing the latest style in sunglasses, or funky jeans for the summer season, spotting trends in forex is a lot harder than in the fashion world. By successfully spotting a market trend, you can jump in earlier and get some great pips. Now although this does tread in the garden of technical analysis, it’s still a very important aspect to consider. I say that this is part of a technical analysis because it does involve getting your information from the charts themselves.
The basic premise of trend spotting is that we need to discern what the market is actually doing, in other words, what is the situation, where is the price going? Once we have established this we can choose which tools to use to help further analyse the trend. In trend spotting there are three ways the price can go; trend up, trend down or ranging. The first two of the three are quite self-explanatory: discerning whether the trend is going up or down. The third example is ranging – this refers to a price trend that is staying between two vertical lines without a clear upward or downward movement. You can see an example of this in the image below of the GBP/AUD pair through the last couple weeks.
As you can see the price seems to be bouncing between the two lines. It seems uncertain and doesn’t go for a clear up or downward trend and can rather be described as moving horizontally. These lines I’ve drawn in yellow are channel lines (which I’ve covered in previous blogs) and the price doesn’t break through these. If you were looking to trade in the ranging period, you would look at placing short term trades, buying near the low price and then taking the profit around the high price. By drawing in channel lines like I have done above, you will more easily spot a trend such as this. However be aware of trying to make out ranging trends where there aren’t any. In more volatile markets it will be harder to spot a ranging trend as the prices will be more likely to go in distinct upward or downward trends.
One way to determine whether a market pair is in a range is to use an Average Directional Index (aka ADX). This tool can be found in the trends drop menu of the indicators tab on your MahiFX account. We’ve tried to have as many tools as possible available to MahiFX users and ADX is just one of the many others you can choose from. It’s quite handy as it helps determine whether a market is ranging or trending. The DI+ measures upward trend movement and the DI- measures downward trend movement. In the image below you can see I’ve added an ADX to the GBP/AUD chart I was previously looking at. The blue line is the DI+ and the green line is the DI-. The white line represents the average and this is the actual Average Directional Index line. This index is measured from 0 – 100: a reading below 25 indicates a ranging market and anything above 25, or even 50 upwards, indicates a strong directional trend. As you can see, whereabouts I’ve drawn in the yellow lines is in the same area as where the white ADX line drops below 25 points. This would have been a good place to make small trades based on small movements between the yellow lines. Bear in mind that this doesn’t show if the market is bearish or bullish but rather just that the market is ranging.
However we are confronted more often with directional trends, price movement that is moving in a distinct direction. These occur more frequently in liquid markets such as majors or crosses that involve the USD. You can use the ADX method as described above, but remember that the ADX reading has to go above 25 before it indicates a developing trend and closer to 50 to indicate a strong trend. However please note that ADX is a lagging indicator and so doesn’t show what’s coming but rather what has/is happening.
Now you may notice that when you see a trend its not a straight line that spike up or downward; the trend zigzags its way along the chart. In light of this I’d like to explain retracements and reversals. A retracement is a temporary price movement that has gone against the prevailing trend. You can spot these because the movement will move against the trend and then return back to it. This is what causes the zigzag movement of the trend line. A reversal is a defined change to the overall trend of the price. For example the price will be trending downward and then will hit a barrier at the bottom then start trending upward. This could happen for a number of fundamental reasons such as I’ve discussed in previous blogs.
When faced with a retracement or reversal, I recommend that you assess the situation using fundamental and technical techniques to decide what the market is about to do. Then decide whether you will hold your position, close and re-enter or simply close permanently. Remember using a stop loss can always be used as a safety net to reduce unexpected losses!