- December 21, 2020
- Posted by: CoachShane
- Category: Trading Article
Trading a retrace in price is a popular technique for swing traders. A retrace is where you see a portion of the prior swing taken out by retreating price action.
The question that always comes up is how much of a price retrace is enough.
- Too shallow of a retracement could simply be a trading range or potential failure test of price highs/low
- Too deep of a retracement could be the end of the current trend
Traders usually look for an objective level such as using a moving average or Fibonacci retracement levels.
Other traders will look for former swing high or lows to target while others will look for previous price ranges.
Whatever method you are using, there is one important variable you must consider: the strength of the prior move.
When looking to trade from a retracement in price, we would like to see the prior leg show intent in a direction.
We will cover that in this article but first…..
Use The 30% Retracement Before Looking For A Trade
If we use the more common ratio of 50%, we will lose many opportunities when the market is in a strong trend.
Using a 30% retracement rule will allow us to:
- Participate in strong trends off of simple corrections
- Allow us room to manage a trade before the previous swing high/swing low comes into play
- Give us an area to watch for the formation of a complex correction
Keep in mind this is a zone we start to look for trades – we don’t automatically jump into a trade.
This is a daily chart of the stock JMIA.
- Strong upward move in price and we pull a 30% retracement measurement from the pivot low to high
- Price gapped down at least 30% of the prior move and we start to look for a trade entry
- This is an outside candlestick pattern and traders could buy off the high of this candlestick
Short time frame players may look at the 30 minute chart for trade entries as we see below.
- Price pulls into the zone and we have a reversal candlestick off the lows (there is former resistance acting as support to the left) which runs $3.00 to the upside before turning
- Obvious reversal candlestick pattern where you buy stop the high or enter next candlestick opening. Price had actually just filled a gap off to the left of the chart.
The 30% retracement gives you an objective area on the chart to look for reversal patterns to trade off of.
Which Swing Points To Use?
As with any talk about retracements, the question is: retrace from what?
Markets move in waves and the lower time frames you trade, the more waves you have.
Nothing is perfect but let’s see if we can have some rules around which swings we consider.
Let’s look at the following sequences:
The first A-B=C in red gives us our zone which looks more like a trading range instead of a pullback. However, it does meet our 30% criteria and traders would have easily found an entry.
Heading back to the first “A” at the bottom left, we would go all the way to the top of that leg for our B. We would not use the trading range, preferring to trade swings, and take the low to high. Price rips through the 30% at “C” and traders would look for the first pause to find entry triggers.
On this chart, we have two prominent swings to use for the final high on the right.
The first A-B in red is from the bottom left of the chart to the top of the right. You can see the red “C” has a reversal candlestick forming and traders would look to trade off of that.
In orange, we take the swing in the middle “A” to the high in orange “B” and gives us an orange “C”. Traders may have found an entry on a lower time frame.
What About The Pullback Strength?
One thing I mention a lot, is to monitor the strength of the pullback. We want to see a low momentum pullback that shows, in the case of an uptrend, not many sellers are interested in unloading.
What we don’t want to see is something like this:
When the pullback has momentum, not only do you see sellers but think of what, visually, it means to potential buyers. After a big move down like this, I like to see a price range before considering a trade in the opposite direction.
Traders may also decide that anything more than a 30% -50 % retrace is too far and shows lack of overall strength.
Other Entries And Stop Loss Locations
There are a few ways to have an entry trigger including chart patterns and even the reverse 30%.
As an example, let’s take a look at this daily stock chart to have a look at an alternative trade trigger.
- This is the beginning of this leg up and after a month, reaches it’s high
- We’ve measured the distance between 1 & 2
- The red line is the 30% pullback off the high of 2 and the momentum into lows could be considered an exhaustion
- We didn’t have an immediate reversal and we did get a few days of sideways movement which confirms that the momentum candle at the end, was more exhaustion than weakness
- We find an objective trade entry by measuring from the high of 2 to the low at 4 which gives us the green line
You could use the reverse 30 to trigger yourself into the trade.
Stop Loss Location
Setting stops takes into account your risk protocols and can often times be limited by your account size. Adjust position sizing when appropriate to give yourself a stop loss that makes sense.
The question is, what makes sense?
Many traders place stop just under swing low or above swing highs. If you don’t add a buffer, you run the risk of being popped out due to price discovery. You could consider using a % of your ATR reading for the buffer zone.
Speaking of the ATR, it’s my favorite way to place stop losses. I start with 1 X ATR and see if that gets me under or over a swing point.
If we are using the reverse 30 method to enter our trade, that means we have short term momentum in our favor. I don’t mind having a slightly closer stop since price, when triggering the trade, is moving away from the stop.
There are quite a number of ways to take profits and we have many trading articles on that topic.
However, this would not be complete without a place to start so let’s keep that simple: take off profits according to your risk.
What does that look like if we use the last example?
All we are doing is scaling out a percentage (usually 33%) when price moves the same distance as our risk.
As price continues up, we would then scale out at 2R and 3R if price goes the distance. In our example, price didn’t make it to the second target so you’d consider exiting the trade when price comes back to the first target.
The 30% retracement strategy takes advantage of the waves in market action. By only taking looking for trades when the first leg of the move is strong, can set us up for a continuation trade.
If price retraces too strongly (look at the size of the candlesticks), you may either not trade the instrument or need to see some type of consolidation pattern.
Why 30% and not 50 or 70%?
We want to ensure we are looking at markets that are strong. Generally, the deeper the pullback the weaker the market is although those trades could at least get you to highs.
New traders who are learning price action and what reversals look like may decide to use the main swing on the chart. Looking for smaller dips can sometimes give you too many decision points.