Let's illustrate this concept with a retracement formed on the 1-hour chart of AUD/USD. Keep in mind: While this specific example uses a 1-hour chart, the underlying mechanism behind its formation holds true across all timeframes. The psychology of trader reactions remains consistent, regardless of the time scale you're analyzing.
In our example, we notice a retracement amidst a pronounced downswing in AUD/USD.
How To Time Reversals: Using Consolidations & Retracements - page 10
What triggers such a retracement during a significant downtrend? The primary cause is banks deciding to take profits from their open sell positions. When the banks lock in their profits, the price naturally begins to counteract the prevailing downward momentum, giving rise to a retracement.
Let's dissect this further...
As the price begins to climb, traders who entered sell positions during the latter stages of the downswing (indicated by the blue box) find themselves underwater. Their positions are now moving against them, leading many to exit at a loss. But how does one exit a sell trade?
By using a BUY ORDER.
Traders must buy back what they sold, but at a worse price. This domino effect has broader implications:
As these traders hurriedly close their losing short positions, a surge of buy orders cascades into the market... amplifying the upward price movement of the retracement. The higher the price climbs, the more traders become convinced this retracement might actually be a reversal. This bullish sentiment compels even those who had shorted earlier in the downtrend to close their positions at a loss.
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An increasing number of traders now enter buy trades, propelling the price even higher. These traders entering are what causes steep upward price spikes—it's the market's way of showing everyone is now entering long!
Price eventually retraces to a level where late-joining trend traders are effectively flushed out by the banks... At this pivotal point, banks enter their sell positions.
But why enter now?
It's straightforward: Banks now have a substantial cluster of buyers they can exploit to make a profit from.
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Banks know their selling will drive prices down... This decline triggers anxiety among retail traders who had optimistically entered long positions, expecting prices to surge. As panic sets in, many hastily close their positions at a loss, inadvertently amplifying the selling pressure…
The result? Price plummets... with even greater velocity.
As prices continue to fall, a ripple effect ensues: More long positions are closed, and a new wave of traders jump in short, aiming to capitalize on the downward trend.
This image illustrates the cascading effect of retail traders closing their unprofitable long trades. Here's the sequence of events:
Banks sell into buying, causing a slight dip in price...
A segment of retail traders decides to exit, pushing the price down...
As even more traders exit, the price plunges significantly...
The further the price falls... the more traders who decide to exit their positions. Additionally, those fortunate retail traders who initially had profitable long trades now begin to see losses and opt to close out.
Eventually, the market reaches a point where the sheer volume of exiting retail traders pushes the price below the retracement low. It's highly likely that most traders who entered long during the retracement phase have closed their positions at a loss by the time the price reaches this level. This is a reasonable assumption given how far the price has moved from their initial entry point—the upper half of the large bullish candle. (We'll explore this concept in more detail soon...)
Re-examine the image: The blue box highlights the area where most traders likely entered long...
**How To Time Reversals: Using Consolidations & Retracements - page 15**
This box encapsulates the steep upward movement just before the price began falling. What prompted so many traders to buy at this point?
The answer is clear—"The Fear of Missing Out." Or, to you and me: **FOMO**!
The Fear Of Missing Out (FOMO)
In the world of trading, FOMO (Fear of Missing Out) is a powerful psychological force that can lead to impulsive decisions and costly mistakes. It's that gut-wrenching feeling that you're missing out on a profitable opportunity if you don't act immediately. Imagine this scenario: You see a sudden, sharp rise in the market, with a series of large, bullish candlesticks forming one after another. It's tempting, right? Those strong signals practically scream, "Jump in now before it's too late!" That's FOMO in action. How To Time Reversals: Using Consolidations & Retracements - page 16 But here's the kicker: FOMO doesn't just affect individual traders; it actually fuels the very movements we see in retracements and consolidations. Let me break it down for you...
Consider the large bullish candlestick which just formed... To many traders, this might confirm a potential reversal or, at the very least, a significant retracement. The sheer size and strength of the candle often convince traders that a reversal or substantial retracement is now underway.
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Always Remember: Large Candles = Strength = Price Direction.
Having seen the price shoot higher, traders scramble to enter long, hoping to capitalize on the anticipated upward trend... But what usually follows?
A sudden reversal. Prices plummet, diving below retracement lows... Coincidence or strategic market manipulation? (I think you know the answer!)
To pinpoint where most retail traders enter during a retracement:
Identify the LATEST significant candlestick (bullish in our scenario).
Find the LATEST substantial multi-candle move in the retracement.
Many traders interpret these signs as confirmation of a retracement or reversal, prompting them to enter. However, when the market shifts, they find themselves trapped, usually leading to hasty exits at a loss. These very traders then become catalysts for the subsequent trend phase, which I've coined the 'liquidation phase' in my "Game Theory" book.
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Here’s how it happens...
When the market moves back to the retracement low, it has fallen by a staggering 160 pips from the point where most traders opted to go long—the latter half of the massive bullish candlestick. This substantial distance strongly suggests that a significant number of these traders have likely exited their positions to prevent further losses...
How can we be so sure?
While Oanda's "Order Book" tool is no longer available, it once provided a valuable insight that supports this assumption:
**How To Time Reversals: Using Consolidations & Retracements - page 19**
Most retail traders tend to close a position once the market moves approximately 100 pips against them...
When the market moves approximately 200 pips from the traders' entry point at the consolidation lows, it's likely—very likely—most of these traders have closed their unprofitable positions. What makes us so certain? Consider this: Oanda's Open Position Graph reveals traders who enter positions during such consolidations usually close once the market moves around 60 pips from their initial entry. How To Time Reversals: Using Consolidations & Retracements - page 32 Take a closer look
Take a look at the open positions graph... I've pinpointed a black dot indicating the retail traders who decided to go short around the 1.0850 - 1.0870 mark. At this point, only 1% of traders are still clinging onto their short positions. It might seem like a significant percentage, but consider this:
Originally, OVER 2% of traders were short at this price level.
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The reduction is due to the market drifting away from where these traders entered. As the market moves further and further away, their losses escalate... By the time the market has shifted 150 pips away from their entry, most have decided to cut their losses.
What happens next?
Banks begin to take profits off their new trades... However, a dilemma arises...
For banks to profit from their sell trades, new sell orders need to enter the market. But with the previous sell orders from retail traders now absent, where do these new orders come from?
The answer: New traders going short.
But as the retracement concludes and the price starts falling, few retail traders are keen on entering short positions... The reason why? The retracement low hasn't been breached.
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This low is crucial as it signifies the threshold the price must cross to establish a new lower low and continuation of the current down-move/downtrend. This is a clear indicator for most traders that the downtrend is back in action. Moreover, those who faced losses earlier are hesitant to re-enter unless they are 100% sure the price will continue falling.
And when might they be tempted to sell again? When FOMO strikes!
In essence, this is triggered when large bearish candlesticks begin to form, beckoning traders to sell into the downtrend again.
When the price breaks below the retracement low, a surge of activity follows as traders scramble to enter short trades. This breach, coupled with strong bearish candles, serves as confirmation that the downtrend has resumed its course, prompting traders to sell in hopes of profiting from the continued decline. The banks seize this opportunity to take profits from their short positions. By strategically buying back portions of their earlier sells into the influx of sell orders from the traders now shorting, the banks secure a substantial profit.
Yet, the very act of banks capitalizing on their profits often triggers another retracement. However, this isn't always the case... Instead of a subsequent retracement, you
might sometimes witness a consolidation or even a reversal.
Regardless of the outcome, the underpinning mechanism remains largely consistent.
By the way...
Did you spot how the subsequent retracement terminated just beneath the previous
retracement's low?
The low is the precise point where most retail traders would have been enticed into
entering short. It begs the question:
Is this a coincidence, or a strategic move by banks to sweep up all the shorts?
(I think you know the answer...)
Key Takeaways:
1. Every retracement, irrespective of its magnitude or duration, follows the outlined procedure above.
2. Retracements during uptrends evolve similarly: Banks take profits, traders enter
short, and subsequently, banks repurchase to propel the uptrend forward.
3. To pinpoint the prevalent trading sentiment during a retracement, look for
the largest candlestick or a significant multi-candle rise/decline which aligns
with the retracement, preceding the price reversal