Trading pullbacks in a trending market is one of the most time-tested Forex trading strategies out there. The beauty of a well thought out pullback trading system is that you enter the market forex trendline strategy clb pdf place your first trade only after confirming which way the market is going.
Since currency pairs remain within a range bound or consolidation phase most of the time, and the market trends only about 20 percent to 30 percent of the time, finding an established trend to trade pullbacks in can be a challenging task. As a Forex trader when you are trying to apply a pullback trading strategy, you need to act like a sniper. Consequently, you need to make sure that you have identified the possible turning point, where the retracement move is likely to end. You need to find a way to generate a high probability pullback signal where the price is likely to resume the prevailing trend. If you can successfully apply a pullback trading system, you can buy low during an uptrend and sell high during a downtrend.
This means your stop loss could be much closer to your entry if you place the order during a pullback or retracement compared to placing the order when the price was moving in the direction of the trend. Apply a pullback trading strategy that offers high-quality trading signals to time your market entry so that you are executing a trade that offers a high reward to risk ratio. Nevertheless, before we dive into discussing real world scenarios and examples, you should get familiar with the theoretical aspects of why trading pullbacks during a trending market work in the first place. You see, most of the time the Forex market remains in equilibrium, where major market participants have access to all the major news developments and information about a particular country’s currency.
However, after high-value news releases about economic fundamentals, if the actual data diverges from the market’s consensus, we can see sharp price movements because here, the market is trying to interpret the new information to find a new equilibrium. Bulls and Bears sometimes have a unique interpretation of developing economic fundamentals, and they put their money behind their respective interpretations. If you have ever watched Level II order flow, you can see how the price triggers each order as prices are moving up or down. Now, once the market starts pushing the price up or down, and establishes a trend, at some point, some traders would start taking profit off the table. Often, you would see that these pullbacks come close to a previous consolidation zone or pivot points on the chart. Often these pullbacks test a prior Support and Resistance level. As a result, when a pullback of the trend reaches these price levels and if there were sufficient orders in the market in the direction of the trend, the market resumes the trend.
Otherwise, the support or resistance levels break, and a trend reversal may ensue in the market. Remember that while identifying a trend can be relatively easy using a naked chart or with the aid of a few technical studies, knowing if the trend is strong enough or gauging the probability of the trend to continue after a pullback is a bit more difficult to accomplish. For most new traders, it is strongly recommended that at the beginning stage that they try to stick to trading pullbacks in a trend rather than engage in counter trend or mean reversion methods. However, as you gain more experience trading pullbacks in the forex market, you can then move on to developing more sophisticated strategies to compliment your trend pullback strategy. But again, if you are a newbie, then you would do best to start by focusing on picking the low-hanging fruit, which in this case is trading pullbacks during a trending market. The first step towards learning how to trade pullbacks is to recognize a trend. If the price on the left of the chart is lower than it is on the right, and making higher highs and higher lows, then you are watching an uptrend in action.
In figure 1, you can see the GBPUSD was on an uptrend, as identified by the Green uptrend line. However, by adding two moving averages, a 13-period Red EMA and a 21-period Green EMA, we can confirm the temporary momentum in the market. When the Red EMA crossed below the Green EMA, it signaled a pullback. As soon as the Red EMA crossed back above the Green EMA, it indicated that the GBPUSD pullback has ended and the uptrend resumed. Similarly, in figure 2, we can see that when the Red EMA crossed above the Green EMA, it signaled a pullback.
As soon as the Red EMA crossed back below the Green EMA, it signaled that the GBPUSD pullback has ended and the downtrend resumed. However, there is a major shortcoming of using EMA crossovers for spotting a pullback or trigger a market entry. If the pullback momentum is not that strong, like in the first instance in figure 2, the EMA crossover might never happen, and the trend may resume, leaving you wondering when to enter the market. Furthermore, an EMA crossover acts as a lagging indicator, and by the time it generates a signal, the market may have moved quite a bit in the direction of the prevailing trend. As a result, the reward to risk ratio of your trade may be decreased as well. Hence, it would be much better that you try to identify a potential reversal area during a pullback and place your trades using more efficient price action based market entry methods.