By Sean Hyman If you’re a news junkie, then you’ve probably heard the traders on CNBC talking about buying on “pullbacks” and selling on “rallies.”

Sounds simple enough right? You’re supposed to buy when a stock (or in our case, a currency pair) just dropped in price, so you can buy at a bargain. You’re also supposed to sell when the price rises, so you’ll get the biggest return on your investment.

But how do you know when to buy or sell? How can you tell if you’re seeing a pullback or a rally?

Easy. You look at “retracements.” They are the counter moves within a larger trend.

You see, whenever you see a trend in the Forex market, you’re really seeing the collective emotion in the Forex market. In fact, most trends are based on human emotion. When a currency pair shoots higher or lower, you’re really seeing how the majority of traders “feel” about that currency pair. In market-speak, you’re looking at the “sentiment” in the markets.

Of course, emotions can get out of hand – even in the markets. Emotion-driven trends get out of hand all the time. Trends temporarily run too far (upward or downward) and need to correct a bit. In fact, traders are constantly overshooting certain currency pairs.

In response, the trend must do a U-turn and head the opposite direction. That’s why retracements happen.

Let’s talk about how to spot a retracement. What do they look like? Check out the U.S. Dollar Index below and you’ll see what I mean.

A Trend Can’t Hold Forever…

You see, the trend above is upward (as noted by the green uptrend line). However, trends never go straight up. They advance (rally) and then they pullback (contract or retrace a bit). Then they rally further, etc. until the trend finally comes to an end (which is where the green uptrend line finally breaks).

Did you know there is a tool out there that will let you measure the depth of retracements and their “likely” stopping/turning points? It’s called Fibonacci Retracement Levels (or “Fib levels”). I’ve talked about it here in FX University before.

But I want to talk about how to use Fib levels to spot a trend. The most common pullbacks within a trend happen at 38.2% of a trend, 50% of a trend, or 61.8% of a trend.

These are the levels when a currency pair is most like to turn back around from its retracement and head back the other direction. When you enter at the likely retracement levels that hold, you set yourself up for a good risk to reward scenario.

In other words, you’re looking at the best time to enter a trade – when you’ll have the highest probability of success.

Let’s take a look below and see what fib retracements look like in an uptrend. When you’re looking at an uptrend, you can choose the fib retracement tool from your charting package (most charting packages include Fib tools for free) and then draw from the very bottom of the trend to the tip top of the uptrend.

Then it automatically plots the retracement levels of that trend.

Fib Levels Predict the Future – and Reveal the Best Entry Points

I’ve accentuated these levels after the trend in green so you can see where I’m talking about. You’ll notice that the daily chart of EUR/USD recently retraced to the 38.2% level, held at that level and then bounced higher.

Once you see what level appears to hold, then you can buy and place a stop below the next lowest fib level.

Okay, so that’s how retracements look in an uptrend. But what about downtrends? After all, there have been tons of downtrends lately as financial markets and certain currencies have fallen all around the world.

Here’s what they look like below.

Follow the Trend Down…And Profit Along the Way

In a downtrend, you would start buy drawing from the highest point of the downtrend and follow the trend’s direction all the way down to the very bottom of the trend.

Then once we let up off of our left mouse click button the retracement levels are drawn. You’ll notice that the numbers reverse, because you’ll retrace 38% of a downtrend first obviously before you’d retrace 61% of it.

As you can see from the daily USD/CAD chart above, so far the 38% level has been the one to hold here as well. You’ll notice both of these currency pairs held at the 38.2% level, but honestly, that’s not always the case. So you should never assume that it will be the Fib level that holds. Make sure your currency pair holds for at least 2-3 candles before diving in.

Once this level held, you could short the downtrend.

Don’t Make These Same Mistakes!

I’m not going to lie. Fib levels are not an exact science, and traders can make mistakes when using this Forex tool. The good news? You can avoid these mistakes if you know what to look for…

When it comes to Fib levels, traders make one of two mistakes. They either don’t allow a trend to complete and make sure to wait for a top or bottom. Or they jump the gun and assume a certain level will hold rather than waiting to see how the market deals with each level first before entering.

To avoid these mistakes, take it slow. Watch your trends develop. You can track them on any charting package.

So just to recap: Retracement levels can give you high probability re-entry points back into the main trend. They are quantifiable through the use of Fib retracements. Since different trends will have different retracement depths, see which fib level/zone tends to hold: 38.2%, 50% or the 61.8% level. THEN enter into the trade as the main trend resumes its direction.

In an uptrend, place your stop BELOW the next lower fib level. If it’s the 61.8% level that holds then pick a recent significant low for your stop. If in a downtrend, place your stop ABOVE the next higher fib level.

If there isn’t a higher fib level (meaning it’s already at 61.8%) then pick a recent significant high point and place your stop slightly above that level.

And as always, take it slow, wait for your trends to develop. Let the market prove you right…it will always pay off in the end.

Happy Trading!
Sean Hyman, aka Professor FX

P.S. Fibonacci levels are a professional trader’s bread and butter when it comes to picking their next winning trades. My colleague Ashish Advani and his entire Exotic FX Alert team constantly watch these levels to choose their next winning exotic trades. (That’s how they grabbed returns of 135%, 227% and 381% for their subscribers.) Could their strategy work for you? Click here to find out.