Why Retracements Work and How to Use Them in Your Trading

This is another one of my favorite trading tips. The first step is to understand why retracements work. The next step is to find a way how to use retracements in your trading.  and I will explain why.

1) Why Do Retracements Work

The reason they work is the actual retracement levels. Most people who look at retracements use Fibonacci levels (e.g. 48.2%, 50%, 61.8%). These are not magic levels. These are not supernatural levels.

Simply put, they work because most people use them. It is common sense. The more people who use any technical indicator and look at the same levels the more significant it becomes.  As a result, a trader can anticipate market behavior and the reaction when a level holds or is broken.

2_ How to use retracements to trade: A common sense approach..

What I mean by common sense is if you look beyond charts and put the market dynamic in perspective, you can look at price action as an opportunity to trade rather than just reacting to it.

Think in these terms…

Let’s say we are in a trend. The market gets overbought or oversold. It needs a shakeout. By shakeout I mean the market needs to squeeze out the weak hands, the weak shorts or weak longs before it can go after a new high or low.

In the case of say a downtrend, the market starts to retrace, it retraces up and eventually stalls after the weak shorts have been shaken out.

Now when a currency retracement starts to reverse, those weak shorts who normally would have bids below the market to take profits, are looking to sell and re-establish.

This sees a lack of bids with fresh selling coming into a market that has less ability to absorb the flows than before the retracement.

Following this logic, the currency (or any market) needs to do now os make a new retracement low or high (as the case may be)  before buyers/sellers come in and resume the trend.

The point here is when you have a retracement and it stalls, beware of the move back in the direction of the overall trend as the market has less ability to absorb the flows than before the market corrected.

XAUUSD chart showing a major uptrend, shallow retracement followed by a new high.

This is why a retracement is often needed before a trend can resume and make a new low or high. If a currency (or any market) does not make a new low or high after a retracement it can give a clue that the trend may be out of steam.

It is a way to understand the price action, how to anticipate market behavior and to use retracements to your advantage. Keep this in mind, it is a common sense approach and one I use in my trading

As always, be aware of the technicals and any levels that would signal a reversal rather than just a retracement.

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