Imagine this scenario. Price starts to rise. Keeps rising. Then it starts falling.
And falling some more. And then it starts going back up.
Have you ever been in this situation before?
It looks as though price action may be rallying and a buy trade is in order.
You’ve been hit by the “Smooth Retracement!”
Nobody likes to be hit the “Smooth Retracement” but, sadly, it does happen.
In the above example, the forex trader failed to recognize the difference between a retracement and a reversal.
Instead of being patient and riding the overall downtrend, the trader believed that a reversal was in motion and set a long entry. Whoops, there goes his money!
Check out how Happy Pip got fooled by the “Smooth Retracement” in one of her AUD/USD trades.
In this lesson, you will learn the characteristics of retracements and reversals, how to recognize them, and how to protect yourself from false signals.
What are Trend Retracements?
A retracement is defined as a temporary price movement against the established trend.
Another way to look at it is an area of price movement that moves against the trend but returns to continue the trend.
Easy enough? Let’s move on…
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:
- 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.
- 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 price sharply moves in one direction. Money is also wasted on spreads if you decide to re-enter.
- You could close permanently. This could result in a loss (if 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 happen at any time, choosing the best option isn’t always easy.
This is why using trailing stop loss points can be a great risk management technique when trading with the trend.
You can employ it to protect your profits and make sure that you will always walk away with some pips in the event that a long-term reversal happens.