It doesn’t take long to figure out that the foreign currencies are constantly in flux. Any chart will show you a series of ups and downs. However, these ups and downs will usually go in one direction over a period of time. The small, temporary downs a currency value experiences are known as retracements. Retracement occurs within a larger upward trend and ultimately do not affect the appreciating value of the currency. However, even the most skilled Forex traders can confuse a retracement with reversal – an actual downward turn in the market.
So how do you know what to do when your currency begins to spiral downwards? If there is truly a reversal happening, then you should be quick to sell off the currency in order to minimize losses. But, if it is only a retracement, then you should hold off selling because the currency will ultimately go up again in value.
Characteristics of Retracements and Reversals
Retracements will typically take place after a large price movement has occurred. They are short lasting, usually shorter than the previous upward movements. There will be no fundamental analytics which predict the downward spiral. In upward trends, a retracement occurs when buying interest is present and thus the value is likely to rally.
By contrast, reversals can take place at any moment, regardless of whether a large price movement has taken place. Reversals are long lasting. In a downward reversal, the downward movements will last longer than the previous upward movements. In an upward reversal, the upward movements will last longer than the previous downward movements. By analyzing the Forex fundamentals, there are typically indicators of the reversal. In upwards trends, there is not much buying interest, thus the value will depreciate. In downwards trends, these is little interest in selling, thus the value with continue to appreciate.
Using Fibonacci Levels for Retracement
One of the most commonly used methods for determining whether a Forex pair is in reversal or just having a slight retracement along the way is to use Fibonacci levels. Under this system, a trader will look at a specific period of time or a specific trend. The trader will pinpoint the high on the Forex chart. From this point, the trader will label the levels of 61.8%, 50% and 38.2%. These levels are based on Fibonacci ratios.
Under the Fibonacci retracement theory, it is normal for Forex value to fluctuate to 61.8%. However, if the currency value goes to 50% or 38.2%, it likely indicates a reversal is taking place. Note that this is not always the case. There are no mathematical formulas which are correct 100% of the time for predicting Forex.
Using Pivot Points for Retracement
An alternative method for predicting whether Forex is in retracement or reversal is using pivot points. If the currency is going upwards, then the trader will locate the lowest support points; in a downwards trend, the trader will locate the highest resistance points. If these points are broken, then it may indicate that a reversal is taking place.
Using Trend Lines for Retracement
The final method for predicting whether a currency is in retracement or reversal is to use trend lines. With this method, the trader pinpoints the highs of a falling trend and uses them to create a line. When the line is broken by upwards movement, then a reversal is likely taking place. In cases of an upwards trend, then the trader pinpoints two low points and connects them to make a line. If these lines are broken by downward movement, a reversal may be in play.