The Anatomy of a Retracement: By Justin Paolini

When trading trends, there are two main principles to insert yourself into the flow:

  • enter on the breakout of some particular level
  • enter on trend resumption after a retracement.

Much has been written about breakouts, so today we’ll take another look at retracements and with the use of our relative strength tool, we will attempt to answer the following questions:

  • what exactly is a retracement?
  • how is it different than a reversal?
  • what augments the probability of trend continuation after a retracement?

Retracements Defined

We have previously touched on the subject of retracements here, and we had described a retracement as follows:

retracements, technically speaking, are nothing more than periods where the market, for whatever reason, runs out of gas and starts to generate a counter-trend movement.

The simplest way to quantify this is to check if:

  • (Current Close – Previous Bar Close) < 0 in an uptrend;
  • (Current Close – Previous Bar Close) > 0 in a downtrend.

In other words, it’s nothing more than a temporary pause or reversal in momentum – end of story.

Systematically Identifying Retracements

Despite the simplicity of the concept, many traders get caught in complications, trying to uncover the secret to “successful retracements” when in reality there is no secret. A retracement can progress into a reversal – we just don’t know what’s going to happen.

What we can do, is identify retracements in a systematic manner. In this article we’re going to use a derivative of our relative strength tool to identify a certain price behaviour.

We’re going to start with the indicator plotted on a weekly EurUsd Chart. The dark black line is the indicator itself with a blended 2 week/5week/7week lookback. We are sticking with this permutation for now because it seemed to do a good job at staying in touch with the market’s rhythm.

In the weekly chart above, the pink line is the derivative of our indicator. The use of derivatives can be explained as follows:

  • the first derivative is the rate of change of the indicator or the slope of the indicator;
  • the second derivative is the rate of change of the slope, or acceleration of the indicator;
  • the third derivative is the rate of change of the acceleration, or jerk of the indicator.

These are all fancy terms but in practice, it all boils down to this:

the derivative hits an extreme when momentum has “jerked” too quickly counter-trend. This is the essence of a retracement: a move that happens counter-trend.

Now let’s zoom into the Daily chart to see one potential usage of these ingredients. The vertical lines are the moment when the Weekly indicator (not the derivative) turned positive (green) or negative (red). On the daily chart I have highlighted the spots where the derivative is indicatingexcess jerk (where the counter-trend move might have used up all it’s gas, hence enhancing thepotential for a trend resumption).

Fairly interesting – and very reactive.

High Probability Retracements

What our indicator shows us is that momentum doesn’t have to “reverse” in order for a pullback to be signalled. We can obtain excess jerk even just from a pause in proceedings.

If we were to rank retracements in terms of higher or lower probability, then pauses in proceedings would probably score more points than deeper retracements. Below is the most representative section of “pauses” in the EurUsd trend. Notice where excess jerk appears.

Now to demonstrate the kind of behaviour that our excess jerk highlights, let’s drill down to a 4H chart and add a traditional oscillator to the chart: a Slow Stochastic. Everyone should realize by now that a stochastic only indicates the position (relative to the lookback period) of current price. Observe what happens to the 4H stochastic in the spots where there is excess jerk.

The stochastic gets “fooled” by the pauses in momentum because it makes deep dips whereas price is simply consolidating.

Over to You

Timeless market dynamics are simple, but not easy to uncover or describe. To sum up our findings, and give you the “recipe” for identifying high probability retracements, our relative strength indicator would sollicit us to say this:

  • identify consolidations that “trick” traditional indicators;
  • look for very little movement in price vs. lots of movement in the indicator.

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.

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