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What is Retracement/pullback signal?
I’m sure you have heard traders say something like:
I’ll wait for a pullback, then I’ll trade it!
Well, a retracement or pullback trade happens when the market breaks through an important range or level, then it comes back to “test” that level again (or the breakout).
The market goes like this:
It breaks through an important level, then it comes back to test that level again… if the market breaks that level back, it would be a false breakout, and the market will trade again inside the range.
But if the market gets rejected from that level, it will confirm the breakout and it could give us a retracement signal.
Now, let me ask you this question:
Are you supposed to take every retracement signal?
Not at all.
In fact, you should only take a handful of them.
And that’s that this article is about, how to know what retracement signals to take.
In order to be valid signal we need three things:
Pressure
At an important level
Significance
Here is what I mean by each aspect of the signal.
Pressure
There are two types of pressure: upward and downward pressure. We have upward pressure when bulls take control over the market after bear dominance and downward pressure when bears take control over the market over the market after a period of bull dominance.
Try to picture this “pressure” on your head, what would it look like? It would look like a “v” shaped pattern as upward pressure or an “inverted v” as downward pressure. Let’s take a look at some images to make sure this is clear.
The first candlestick moves down (bear dominance – red arrow), but at some point, bulls gain confidence and take control over the market (i.e. bulls felt comfortable trading at those levels) pushing the market back up (bull dominance – blue arrow).
If we combine both arrows, we end up with a v shaped pattern (green arrow) with upward pressure.
Does it mean that only known candlestick patters (such as piercings, hammers, shooting stars, etc.) have either upward or downward pressure? NO. In fact, most patterns that have either upward or downward pressure aren’t known candlestick patterns. Take a look at the next image.
This pattern is not known in the candlestick literature, but it still has upward pressure. You still see the “v” market movement. Next time you see a candlestick pattern, try to picture it in your mind as “v” or “inverted v” pattern, this way you will train your brain to see them as price action, not just as a candlestick pattern. At an important Level
Another important concept that describes Forex Price Action, is how the market behaves at a place it already traded before.
I suspect the reader already knows what we are talking about, if the market was rejected from an important level, the next time it comes close to that level, it is likely to get rejected again. And yes, we are talking about regular support and resistance levels.
This is the reason why we always need to pay attention on where the market has been rejected, specially the short term Support & Resistance levels, because at those levels we always should be ready to open our trades (in the direction of the long term market condition). Please take a look at the next chart:
In this chart, where would you open your trades? If I was to trade this chart, I would look for long opportunities around the bottom of the range, because the market gets rejected every time it gets near that level. And short opportunities around the top of the range, again, because every time the market gets close to this level the market gets rejected.
Significance
Due to the nature of the Forex market (OTC: over the counter), it’s impossible to get an exact reading of the volume of the market at any given moment. But there are certain measures that can be used as a “proxy variable”, one of them is the significance of the “pattern”.
The significance of the pattern refers to the size of the pattern that triggered the upward/downward pressure compared to the previous candlesticks.
If we are tracking a “long” signal, we need to compare the size of the pattern that triggered our long signal to the bear candlesticks that formed the previous downward movement.
And vice versa, of we are tracking a “short” signal, we need to compare the size of the pattern that triggered our short signal to the bull candlestick that formed the previous upward movement. Let’s take a look at some images.
The trigger signal in the image above is clearly larger than any of the 3 previous candlesticks that formed the upward movement; therefore it is a significant pattern.
Putting it all together
Please take a look at the next chart:
The pattern (orange square) with downward pressure is formed at an important short term resistance level (green line) and it is also significant (pattern larger than the previous candlesticks). This is considered to be a Forex price action signal to go short.
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