You have probably heard the word "retracement" or "retrace" a lot when you are interested in trading in financial markets. But do you really know what price tracking is, why it is so important, and how to use it properly? Perhaps not, but even if you do, today's lesson will shed new light on leveraging these extremely powerful market events …
Retracement in a market is a fairly easy concept to define and understand. Simply put, it is exactly what it sounds like: a time when the price is due to a recent move, either up or down. Remember to "retrace your steps". Go back the same way you came. It is basically a reversal of a recent price move.
Why are retracements important? For a number of reasons: They offer the opportunity to enter the market at a "better price", enable an optimal stop-loss placement, an improved risk reward and much more. For example, a retrace entry is more conservative than a "market entry" and is considered a "secure" entry type. Ultimately, the goal of a trader is to get the best entry price, manage risk as best as possible, and at the same time increase return. The retracement entry is a tool that you can use to perform all three tasks.
This lesson covers all aspects of retracements and helps you better understand and use them to hopefully improve your overall trading performance.
Now let's discuss some of the pros and cons of retracement trading before we look at some sample charts.
Benefits of retracement trading
Let's talk about some of the many "benefits" of retracement trading. To be honest, retracement trading is basically how you act like a sniper. If you have followed me for a long time, you will know that this is my preferred trading method.
- More likely entries – Due to the nature of a retreat or retracement, the price is likely to continue moving in the direction of the initial move when the retraction ends. So if you see a strong price action signal at a level after a retracement, this is an entry with a very high probability, since all signs indicate that the price will jump from this point. Well, it doesn't always happen, but waiting for a signal to return to a level is the most likely way you can trade. The markets keep turning back to the “average price” or the “average price”. This becomes clear when you look at a price chart for a few minutes. So if you see this rotation or tracing taking place, look for an entry point there, as this is a much more likely entry point than if you simply entered "in the market" like most traders.
- Less early stops – A retracement allows more flexibility in stop loss placement. Mainly by allowing you to place the stop further away from any area on the chart that is likely to be hit (if the trade you are making is training at all). Placing stops further away from key levels or moving averages or further away from a high or low pin header gives traders a higher chance of training.
- Better risk premiums – With retracement entries, you can theoretically put a "narrower" stop loss on a trade, because you participate closer to a key level or at a pin bar level of 50%, for example, in a trade entry trick entry. If you choose to do so, you can place a stop much closer than if you entered a trade that did not take place after a retrace, or if you entered a pin-bar trade at the top or bottom of the pin, for example. Example: A 100-pip stop and a 200-pip target can easily become a 50-pip stop and a 250-pip target on a trace entry. Note: You do not need to place a closer stop, this is optional, but the IS option is available for a retrace entry if you wish. The alternative of using a standard width stop has the advantage of reducing the likelihood of an early stop.
- A risk reward can also be increased slightly, even if you use a standard stop loss instead of a "narrower" one. Example: A 100 pip stop and a 200 pip target can easily become a 100 pip stop and a 250 pip target. Why? This is because a trace entry can enter the market if it has "more space" to run in your direction. This is due to the fact that the price has decreased and therefore there is more freedom of movement before it is traced again than if you entered at a "worse price" above or below.
Disadvantages of retracement trading
Of course, I will be honest with you and inform you about some of the "disadvantages" of retracement trading. There are a few that you should be aware of. However, this does not mean that you should not try to learn retracement trading and add it to your trading toolbox as the advantages far outweigh the disadvantages.
- More missed trades: Good trades will sometimes "escape" if, for example, you wait for a retracement that does not take place. This can test your nerves and trading mentality and annoy even the best traders. But believe me, it is not the worst thing in the world to miss trades, and it is certainly better to miss some trades than to trade too much.
- Fewer trades in general – in most cases, markets simply don't pull back enough to trigger the more conservative entry that comes with a pullback. Instead, they can just go ahead with minimal retracements. This means that overall you have less chance of trading compared to someone who is not primarily waiting for traceability.
- Because of the two points above, retracement trading can be frustrating and requires incredible discipline. However, if you develop this discipline you will be GOOD ahead of the masses of lost traders. Therefore, retracement trading can help you develop the discipline you need to trade successfully, regardless of which entry-level method you ultimately use.
Retracements offer flexibility in stop-loss placements
If you place your stop loss in the wrong place, you can be prematurely excluded from a trade that you were otherwise entitled to. If you learn to wait for market retractions or retracements, not only are you more likely to enter the market, but you can also place your stop loss at a much safer point on the chart.
- Dealers are often discouraged because they are excluded from a trade where they were technically correct. If you place a stop loss in the wrong place on a chart, you can be taken out of a trade before the market really has a chance to go your way. A retracement offers a nifty solution to this problem by allowing you to stop a trade more safely and comprehensively, giving you a better chance of making money on that trade.
- If a market is retracing or retreating, especially within a trend market, you have the option to place your stop loss at a point on the chart where you are much less likely to be excluded from a trade. Since most traceability is at support or resistance levels, you can place the stop loss further beyond that level (safer), which is much less likely to be hit than if it is closer to the level. In this case, if you use a so-called "standard" stop loss (not a narrow one), you have the best chance of avoiding a premature shutdown of a trade.
The different retrace entry types: Examples
Next, let's look at some of the different retrace entry types so you can get a clear view of what they might look like.
- Tracing the entry without a price action signal
The following example shows how the price is traced or retracted to the horizontal key level shown in the graphic. There was no obvious price action signal here, but we can see that the price of this level quickly sells out after barely exceeding it. This offered traders a very high risk / reward scenario if they made a "blind entry" at the level with a tight stop loss …
- Return at key level with price action confluence
Perhaps my favorite trading strategy of all time is the following example: wait for the price to return to an existing key level in the daily chart timeframe and then make sure that an obvious price action signal is forming there. In my opinion, this is the most likely way to act …
- Back to the moving average (rotation to the mean)
Markets tend to return to the average or average price, which you can see if you add a moving average to your charts. Below is the 21-day ema, a solid short-term moving average to see the trend on the daily chart. If the price returns to this level, you should pay close attention to the fact that price action signals form there in order to be very likely to get in and to enter a trend market.
The price tends to track around 50% of all major movements and often even short-term movements. This is a well-documented phenomenon, and if you look at a diagram, you can see that it happens a LOT. Therefore, we can look out for retreats into these 50% areas, as they very often represent an impressive level that the price moves beyond, and as a result the price moves back from the 50% level in the direction of the initial move. It doesn't happen EVERY time, but it happens often enough to make it an important tool in your retracement trading toolbox.
- Traces the entry of a signal bar or a signal area
Another way to use retracements is also very effective, but it differs a little from those already discussed. What we see below is what I call "50% Pin Bar Retrace". For longer-tailed pin bars, you'll often see price drops about half the distance from high to low on the signal bar. This gives you the opportunity to get in at a better price and achieve a safer or narrower stop loss.
Example 1: Below you can see how a 4R win could be made by waiting for the return and entering close to the 50% level of the pin.
Example 2: You can see below how a 2R win could be made by waiting for traceability and entering close to the 50% area with fake patterns.
- Track entry back to an event area or previous PA signal
If the price returns to what I call the "event area", it is a very likely area where trades can be searched. As you can see below, the price goes back to an existing event area where a pin-bar signal has formed, and then forms another (this time bearish) pin-bar before a big sale takes place …
You now have a solid introduction and (hopefully) an understanding of what price promotions are, why they are important, and how to trade them. While this lesson contains a little more than what I've discussed here, it does give you a good foundation to build on, and gives you some tools to start your trading routine this week and in the future.
If you want to learn more about retracement trading and want to be informed daily about possible retracement trades, read my professional trading course and follow my daily trading setup newsletter. This deepens your understanding of retracements as well as helps you apply these concepts to real-time price action signals. You can then test and compare the results between aggressive entries (as in this article) and traditional entries that you probably know better. Remember I'm always here to help you and share my knowledge with you. So keep learning and practicing.
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