The market is inherently unpredictable, and retracements can turn into reversals without any warning. That’s why it’s important to use trailing stops when trading in a trending market environment. By using trailing stop losses, you can save yourself from exiting a position too early during a retracement, or if it is a reversal, it can help you to get out before you make a sizeable loss.
Ultimately, it takes time and experience to be able to distinguish retracements from reversals. Knowing how to do this will go a long way towards reducing losses and preventing winners from turning into losers.
One of the keys to this is being able to see when a trend is weakening, and there are plenty of tools that you can use to this end, such as:
- ADX (Average Directional Index Indicator) – shows the strength of a trend, the higher the number, the stronger the trend. If this number is falling, it may indicate that the trend is weakening.
- SMA (Simple Moving Average) – When you place three SMAs of different time periods on a chart, it can indicate when a trend is beginning or ending. Usually, if the lines compress then fan out, it indicates a reversal, so if they start to compress, it could be a sign that the trend is weakening.
- Bollinger Bands – by setting up two Bollinger bands on your graph with different standard deviations, you create three zones – a buy zone, a sell zone, and the space in between. When the price action edges from one zone to another, it may indicate that the trend may change soon.
- Doji – These candlestick formations, with a narrow real body, can sometimes occur before a reversal. For more about using Doji to predict reversals, check out Part 2 of our Guide to Forex Trading with Candlestick Charts.
Using indicators such as these, along with plenty of practice and experience, you should eventually start to get a feel for when a trend is ending and a reversal is on the way. This, together with the use of trailing stops to lock in profits and shield you against downside risk, can be a very useful tool for increasing your profits and minimising losses.