Knowing Your Trading Markets Environment!

When two people go to war, the foolish man always rushes blindly into battle without a plan!

The wise man, on the other hand, will always get a situation report first to know the surrounding conditions that could affect how the battle plays out. Like in warfare, we must also get a situation report on trading environment. This means we need to know what kind of market environment we are actually in.

Some forex traders are always complaining saying that their system sucks, Well, sometimes the system does in fact…suck.

Other times, the system is potentially profitable, but it is being utilized in the wrong trading environment. Seasoned forex traders try to figure out the appropriate strategy for the current market environment they are trading in.

Has price broken out of the range and look for Retest/retracements? Or are ranges holding?

Just as the coach comes up with different plays for particular situations or opponents, you should also be able to decide which strategy to use depending on the trading environment.

By knowing what market environment we are trading in, we can choose a trend-based strategy in a trending market or a range-bound strategy in a ranging market.

The forex market provides many trending and ranging opportunities across different time frames wherein these strategies can be implemented.

Knowing which strategies are appropriate, you will find it easier to figure out which indicators to pull out from your forex toolbox.

For instance, Fibs and trend lines are useful in trending markets while support and resistance levels are helpful when the market is ranging.

Before spotting those opportunities, you have to be able to determine the trading environment. The state of the market can be classified into three scenarios:

• Trending up
• Trending down
• Ranging/Consolidating

Trending Market

A trending market is one in which price is generally moving in one direction.

Sure, price may go against the trend every now and then, but looking at the longer time frames would show that those were just retracements.

This is an Example of a DOWN-TREND

Trends are usually noted by “higher highs” and “higher lows” in an uptrend and “lower highs” and “lower lows” in a downtrend.

When trading a trend-based strategy, traders usually pick the major currencies as well as any other currency utilizing the dollar because these pairs tend to trend and be more liquid than other pairs.

Liquidity is important in trend-based strategies. The more liquid a currency pair, the more movement (a. k. a. volatility) we can expect. The more movement a currency exhibits, the more opportunities there are for price to move strongly in one direction as opposed to bouncing around within small ranges.

Ranging / Consolidating Markets

A ranging/Consolidating market is one in which price bounces in between a specific high price and low price. The high price acts as a major resistance level in which price can’t seem to break through. Likewise, the low price acts as major support level in which price can’t seem to break as well.

Market movement could be classified as horizontal or sideways.

Trend Retracement or Reversal?

Imagine this scenario. Price starts to rise. Keeps rising. Then it starts falling.

And falling some more. And then it starts going back up.

Have you ever been in this situation before?

It looks as though price action may be rallying and a buy trade is in order.

WRONG!

You’ve been hit by the “Smooth Retracement!”

Nobody likes to be hit by the “Smooth Retracement” but, sadly, it does happen.

Why?

In the above example, the forex trader failed to recognize the difference between a retracement and a reversal.

Instead of being patient and riding the overall downtrend, the trader believed that a reversal was in motion and set a long entry. Whoops, there goes his money!

So, What are Trend Retracements?

A retracement is defined as a temporary price movement against the established trend.

Another way to look at it is an area of price movement that moves against the trend but returns to continue the trend.

Easy enough? Let’s move on…

What are Trend Reversals?

Reversals are defined as a change in the overall trend of price.

• When an uptrend switches to a downtrend, a reversal occurs.
• When a downtrend switches to an uptrend, a reversal also occurs.

Using the same example as above, here’s how a reversal looks like.

What Should You Do?

When faced with a possible retracement or reversal, you have three options:

1. If in a position you could hold onto your position. This could lead to losses if the retracement turns out to be a longer term reversal.
2. You could close your position and re-enter if the price starts moving with the overall trend again. Of course, there could be a missed trade opportunity if price sharply moves in one direction. Money is also wasted on spreads if you decide to re-enter.
3. You could close permanently. This could result in a loss (if price went against you) or a huge profit (if you closed at a top or bottom) depending on the structure of your trade and what happens after.

Because reversals can happen at any time, choosing the best option isn’t always easy.

This is why using trailing stop loss points can be a great risk management technique when trading with the trend.

You can employ it to protect your profits and make sure that you will always walk away with some pips in the event that a long-term reversal happens.

You Probably wondering, how do i Identify Reversals?

Properly distinguishing between retracements and reversals can reduce the number of losing trades and even set you up with some winning trades.

Classifying a price movement as a retracement or a reversal is very important.

There are several key differences in distinguishing a temporary price change retracement from a long-term trend reversal. Here they are:

RETRACEMENTS

• Short-Term, Short Lived Reversal.
• Usually occurs after huge price movements.
• Fundamentals (i.e., the macroeconomic environment) do NOT change.
• In an uptrend, buying interest is present, making it likely for price to rally. In a downtrend, selling interest is present, making it likely for price to decline.

REVERSALS

• Can Occur anytime
• Long-Term Price Movement
• Fundamentals DO change, which is usually the catalyst for the long-term reversal.
• In an uptrend, there is very little buying interest forcing the price to fall lower. In a downtrend, there is very little selling interest forcing the price to rise further.

Identifying reversals using Trend Lines

When a major trend line is broken, a reversal may be in effect.

By using this technical tool in conjunction with candlestick chart patterns discussed earlier, a forex trader may be able to get a high probability of a reversal.

While these methods can identify reversals, they aren’t the only way. At the end of the day, nothing can substitute for practice and experience.

With enough screen time, you can find a method that suits your forex trading personality in identifying retracements and reversals.