The third and final strategy we will add to our trading arsenal is the strategy of retracements. A retracement is a scenario in which a trend is already in existence and price begins to move counter, or opposite the trend. In other words, if price has been moving up for an extended period of time and then it begins to travel sideways or downwards, this is a retracement. A retracement is declared in hindsight because a retracement is by definition a pause in the continuation of a trend. If the trend does not continue upwards, but rather reverses downwards, this would be a reversal, not a retracement. A retracement cannot be declared a retracement until it clears the highs of itself. This can be difficult to understand in words, however a simple representation of a retracement may greatly aid in gaining a conceptual grasp.
The above image represents the ideal world. However, the real world rarely behaves according to our expectations. In the real financial markets, retracements can be as short as one candle or as long as several. A retracement is easy to spot while looking at history, however during live trading, it can be difficult.
In order for a trader to identify and profit from a retracement, he must approach the trade with a predetermined plan and expectations of how he expects price to behave. If a trader sees a retracement forming, he should not blinding purchase or sell the security, but should rather wait until the best opportunity presents itself. There are two moments which are appropriate for trading a retracement. The first is if the retracement hits a trend line. If a trader is actively monitoring the market and he sees a security retracing towards a trend line, his best course of action is to wait until price nears the trend line and trade in the direction of the primary trend with a stop a short distance beneath the trend line. This allows him a low risk opportunity to enter a trade in the direction of an existing trend. The second opportunity for a trader to trade a retracement is the break of the highs of a retracement. This is in effect a "breakout" which is described on a previous page. When price clears a retracement, this is an excellent opportunity for the trader to enter with a relatively low risk in the direction of the primary trend. As soon as a retracement is cleared and begins to form new highs, it is appropriate for a trader to follow trend following rules for stop placement and put stops beneath (if price is trending upwards) or above (if price is trending downwards) prior retracements.
When a trader is buying or selling a retracement, they are expecting momentum to resume in the direction of the trend. They believe that trends, once they are in motion, tend to stay in motion and that profit can be found by identifying and trading in the direction of the trend. By trading retracements, individuals are following one of the oldest sayings about the markets "the trend is your friend".
Above is a picture of market activity showing a trade which is initiated using retracements.
Summary - How to Trade a Retracement
1. Initiate a trade in the direction of the trend as soon as a retracement touches a trend line or it breaks its previous highs.
2. Place the initial stop below the lows of the current retracement or a short distance beneath the trend line.
3. Move the stop to progressively higher retracements as soon as a retracement forms and then clears.
4. Never trade against the primary trend.