How to Profit from Market Retracements

What is your #1 job as a trader?

A trader’s main job is to organize market information into an identifiable sequence, providing an edge. This edge is the result of a statistical advantage from a given set of trades over time.

In this article we will look at how to…

  • Determine an edge in the context of the larger trend
  • Enter into a trade at a predetermined retracement level
  • Understand market behavior and avoid common challenges

The market is said to be continually retracing. At a quick glance of any basic chart it’s pretty apparent. The market goes up, it pulls back, and it goes up again. Other times the market goes down, rallies, and goes down again. Time after time the process repeats itself.

So how then do we make sense of the market information? One method is to identify the larger trend and look to enter in the direction of that trend once a retracement has occurred.

What is a Retracement?

A retracement is simply a short-term reversal in the trend, a pullback in an uptrend or a rally in a downtrend.

The market rarely moves higher or lower in a straight line. After a market has made an initial push, we often see a reversal, a retracement in price. Given the frequency of this occurrence we are able to get into the market at this retracement level and take part in the larger move.

How to Think Like a Trader

It’s time to train you brain to think like a trader and trade off what you see, not what you think. Traders think with their eyes, not with their brains. Said another way, traders do not try and predict what will happen; they trade off the data in front of them.

Remember the market is always right and anything can happen.

The Psychology Behind the Market

Forget about Fibonacci, Moving Averages, or fancy indicators for a minute. Let’s try and understand what is happening on a psychological level when price breaks out and pulls back.

Example: A group of investors believe a market is going higher so they begin to buy in large size. This slowly pushes the market higher. Traders notice the movement and begin to jump on board.

After breaking highs the move higher becomes clear. The retail traders feel they will miss out of they don’t get in now so they proceed to buy last, and at highs.

The professional traders and shorter-term hedge fund players close out their positions as we make new highs. And who do they sell to? Why to the retail traders that were chasing the move. It’s at this point that the market begins to selloff.

Once we have pulled back say halfway, the original investors decide to add to their position just as the retail traders who were chasing the move are getting their stops hit and exiting for a loss. With investors adding to their already profitable position this sends the market higher once more, and the process repeats.

When to Place Your Trade

Buying pullbacks in an uptrend and selling rallies in a downtrend is a great strategy, but how do we know when the short-term reversal is over and the larger trend is ready to resume? We don’t. What we do know, is that markets tend to retrace 50% of a given move, or come halfway back before resuming the larger trend.

To stay with the theme of simplicity, there are three steps to follow when placing a trade…

 Step 1: Identify the Trend

Step 2: Determine the Entry Point

Step 3: Order Execution

Simple, yes. Easy, not exactly. Let’s take at look at each step individually with some examples. (I repeat this process for each market that I am trading).

Step 1: Identify the Trend

The first thing to do is identify the larger trend. An uptrend is made up of higher highs and higher lows and a downtrend is made up of lower highs and lower lows (the time frame is irrelevant).

I prefer to start on a weekly chart and drill down to the smaller time frames. Whether you trade intraday or off daily levels, the process is the same. I use 4 time frames, a weekly, daily, 15-min, and 512 tick.

If you’re unfamiliar with tick charts, each bar forms after X amount of ticks are traded (in this case 512). On a typical time based chart, each bar forms after a specified period of time has elapsed, such as 15-mins.

(More on tick charts and the screen setup that I use can be found on my blog, EminiMind.com).

Exercise: Print out a 5-min chart of any market and go through and identify the highs and lows that make up the trend. Use a pen to draw arrows in the direction of the trend (you will notice sometimes however, there is no trend as the market moves sideways).

I consider the larger trend one time frame higher than my entry time frame. So if I’m trading on a 512 tick chart I will look to the 15-min chart as the larger trend and if I’m trading off a 15-min chart I will look to the daily chart as the larger trend etc.

Step 2: Determine Your Entry Point

Once you’ve identified the trend, watch for a retracement to occur. I look for a retracement of 50% of the initial move, also known as halfway back.

Interesting Fact: Some pit traders will use the first hours range as the initial push and look to enter in the direction of that trend once price retraces half of the move.

This halfway back level is the entry point. Sometimes the larger trend resumes before it makes it all the way halfway back, other times it trades through the halfway back level.

Here are two ways I handle the preceding issues which have shown to increase my winning % and profitability…

  • Place orders just in front of the halfway back level
  • Scale out a portion of the position at a small profit target

This brings us to the third step…

Step 3: Order Execution

I only use limit orders. Since I have predetermined my entry price I let the market come to me. I will place my orders a few ticks/pips in front of the 50% retracement level in order to get filled. This is because most markets need to trade through your price to give you a fill.

Placing orders just in front of the 50% retracement ensures that if price stops and reverses at the 50% level exactly you will be filled and in the trade.

What if the market trades through the 50% retracement? This will certainly happen, however I’ve found that the markets will usually give some sort of bounce at these levels before breaking through or resuming the larger trend. For this reason I exit a portion of my position at a small profit target to reduce my risk on the trade. Over time, this method of reducing my risk helps eliminate full stop outs.

3 Challenges You May Face With This Strategy

No strategy is perfect, but I’ve found a lot of the mistakes and errors that occur are internal, they lie within us. Trading is mostly a mental game and these are some of the challenges I faced along the way.

Making it more complicated than it needs to be. With so many different methodologies out there, pick one and stick with it, I try to minimize my trading screen of all the clutter and only look at things that directly relate to my trading method. The addition of other indicators and news feeds just creates second guessing.

Fear of Pulling the Trigger and Hesitating. Use limit orders and place them in advance, then sit back and wait for your fill. If you have to physically sit on your hands or stand 3 feet away from the computer do so. Once you’ve identified the highs and lows of a move and draw up the halfway back you know where your entry is giving you plenty of time to place your limit order.

Going against the trend. In all cases when price is coming into your limit order it will be going against the larger trend. It’s important to keep the bigger picture in mind and not lose sight of the larger time frame. I think in terms of groups of trades versus each individual trade individually. This is just another way to look at the data and stay objective.

Conclusion: What to Do From Here

Now that you’ve familiarized yourself with the retracement strategy you will want to pick a market that has a good risk/reward ratio. I like the Euro (6E). It adheres to the setups well and has very large price swings every day, providing great trading opportunities.

Begin with step 1 and pull up a simple candlestick chart with no indicators. Go back as far as you can and look to identify the trend and retracements within the larger trend.

In time the trend and retracements will become clearer and easier to identify. Reviewing the setups each night will help build confidence when it comes time to pull the trigger.

You can find more details about the retracement method, and the specific setups I use on my blog EminiMind.com under the ‘Trading Rules’ tab.

By Tim Racette

Trading involves substantial risk of loss and is not suitable for all individuals. Past Performance is not indicative of future results.