You will hear a lot about retracements in Forex, in particular that you should trade off of them. While the word “retracement” is often found in the context of Fibonacci retracements, it is a broader, more general topic, and quite often people referring to retracements are not referring to Fibonacci levels at all. What is a retracement in Forex? Quite simply, a retracement is any temporary reversal in price within a major price trend. The word “within” is the key here. That is the difference between a reversal and a retracement. A reversal is the end of the price trend and either the beginning of a new one or the beginning of a period of consolidation. A retracement is just a temporary interruption.
When you look at Forex charts, you will notice that the market always moves in this general manner. Within most trends in most time periods, even very strong trends, retracements are how the market moves. You can think of it as two steps forward, one step back, two steps forward, one step back. Retracements occur during both bullish and bearish trends. Fibonacci retracements are retracements which occur at Fibonacci levels. Price often hesitates around Fibonacci levels, which act as support and resistance. The reason they do this is basically because traders expect them to and behave accordingly.
Why do retracements matter to you as a Forex trader? Retracements, while easy to confuse with reversals, can actually be a confirmation of a trend. They can help you find a good context for a great trade — especially if they are retracements to Fibonacci levels. Many traders will wait until the retracement has occurred before they enter into a trade at the start of a trend. Why wait? If you enter before the retracement, you will not know if you are in a retracement or a reversal once price turns around. If you wait until after the retracement though, you not only are less likely to get faked out by a false trend, but you are also more likely to be in on a real trend since you will have the retracement level then acting as support or resistance in favor of your position.
Retracements are a great tool in your Forex toolbox, so learn to start spotting them. They do not have to be at Fibonacci levels in order to serve you well, but a Fibonacci level retracement is often doubly strong. To draw Fibonacci retracement levels, go into your charting software and select the Fibonacci retracement tool. Select the most recent swing high (or swing low), and draw a line from one to the other. The Fibonacci levels will be automatically calculated and displayed for you. If you select more than one swing high and low and draw the levels twice (once for each set of extremities), you may see confluence between some of the levels — meaning that two Fibonacci levels overlap on top of each other on the chart. This can function as an extra strong level of support or resistance. If price retraces off of Fibonacci confluence and you have a setup, that can be an opportunity for a top rate FX trade!