September 07, 2017
Not every trading strategy is suitable for every market environment. Traders need to know the current state the market is in, to determine which strategy will achieve the best trading results. For example, Fib retracements and trendlines are very useful in trending markets, but in a ranging market you would be better suited with pivot points or support and resistance levels. That’s the reason why it’s so important to know which state the market is in:
- Trending up or down
A market is trending if the price makes consecutive higher highs and higher lows for uptrends, or lower highs and lower lows for downtrends. You can simply draw a trendline to determine whether the market is trending up or down. The following chart show a market trending up, making higher lows all the way up.
The ADX indicator can be used to determine if a market is trending or ranging. This indicator has a value of above 25 if the market is trending, and below 25 if the market is ranging. The following chart shows the ADX indicator with values above 25 (green) and values below 25 (blue). You can use this indicator as a confirmation that a trend has started.
A range-bound market, as the name suggests, is a market environment where price trades horizontal or sideways. The price stays inside a range of a higher price and lower price, where the higher price acts as resistance, and the lower price as support. The following chart shows a range-bound market.
Just like with trending markets, we can use the Average Directional Movement Index (ADX) indicator to identify ranging market conditions. Remember, an ADX value above 25 indicates a trending market, while a value below 25 indicates a ranging market. The following chart shows how to use the ADX indicator to spot a range-bound market.
An ADX-value below 25 is marked with blue rectangles, and shows that the market is not trending enough to push the value of the indicator above 25. This defines a ranging market condition. On the other hand, the green rectangles where the ADX is above 25 show a market which is trending (making higher highs or lower lows).
Retracements vs. Reversals – What is the Difference and How to Identify Them?
Retracements and reversals can often look the same for traders new to forex, that’s why it’s important to exactly know the difference between them.
A retracement is simply a short-lived price movement which goes against an established trend. Retracements often form higher lows during uptrends (and lower highs during downtrends), confirming that the overall trend is still intact. They can also form after huge price movements, but the underlying fundamentals of the currency pair do not change, pushing the price back in the direction of the trend. Retracements are usually measured with the Fibonacci retracement tool, which we have covered in earlier lessons.
Reversals, on the other hand, can occur at any time with the underlying fundamentals of the currency pair changing. After a reversal, a new trend establishes which makes higher highs in an uptrend, or lower lows in a downtrend.
Let’s look at the next picture to see how retracements and reversals look in the market.
The left part of the chart shows a downtrend, with retracements marked with green rectangles. They go against the trend for a short time, and make lower highs before finally going back in the direction of the overall downtrend. The lower highs and lower lows show that the downtrend is still intact.
Eventually, the price forms a higher high (red arrow in the middle of the chart), signaling that a reversal into an uptrend may be ahead. After that, the price was forming higher highs and occasionally retraced to form higher lows, confirming that the new uptrend is intact.
How to Protect from Reversals?
As you already know, reversals can happen at any time when the underlying macroeconomics of a currency pair change. So, if you have an open position, you need to be prepared any time for a reversal and lock your hard-earned pips. Stop-losses are mandatory in any trading strategy, and you can even use trailing stops to prevent exiting too early, but still be secured in the case a reversal happens.
Trailing stops simply follow the current price, and automatically adjust the stop-loss to be a certain number of pips away from the current price. So if you are in a winning position, trailing stops will automatically adjust to lock your profits in case of a reversal.