What You Can Learn From Shallow Pullbacks

Shallow pullbacks are the other type of pullback which can occur in the forex market. I’ve spoken a little about shallow pullbacks before in my understanding pullbacks article, but today I want to take an in-depth look as to what shallow pullbacks can tell us about the market environment.

 

What Are Shallow Pullbacks ?

 

A Shallow pullback is a type of pullback which terminates anywhere before the 38.4% Fibonacci retracement level, if you see a retracement breach the 38.4% level then what you’re seeing is not a shallow pullback and instead is closer to being a 50% retracement which we know is not something we want to be trading.

Shallow pullbacks get their name from the distance the market manages to retrace, in deep pullbacks the retracement will end towards to beginning of the swing you’re drawing the retracement from, hence the name deep, because the market drops deep into the previous swing. Shallow pullbacks always end close to the end of the swing your drawing the retracement from, therefore the distance the price manages to travel into the swing is short, giving us the name shallow as the price cannot move far into the swing.

There are big differences between shallow pullbacks and deep pullbacks…..

The main one being you’ll usually see deep pullback when a trend reversal is taking place due to the way the banks want to get a lot of trades placed in the direction of the reversal, shallow pullbacks on the other hand will tend to form when the market has been trending in the same direction for a long time.

Whilst you will most commonly see shallow pullbacks form during long trends there will be times when you see them during trend reversals. The reason they can form at reversals is due what traders believe about the future market direction as the reversal is taking place.

A deep pullback can only form if the majority of the traders believe the market has the capability to continue moving in the prior trend direction, a shallow pullback seen at a trend reversal means the first movement in the reversal has been so strong that most traders do not believe the market can continue in the direction of the previous trend, therefore the traders will be placing trades in the direction of reversal movement as opposed to continuing to trade in the direction of the trend which is what causes deep pullbacks to form.

 

How Are Shallow Pullbacks Created ?

 

Shallow pullbacks, like all other pullbacks in the market, form because of profit taking by bank traders.

The reason the market only manages to retrace to the lower Fibonacci levels i.e 23.4% – 38.4% is because of the way retail traders will continue to place trades in the direction of the trend even when the shallow pullback is taking place. They do this because they are sure the previous trend is going to continue, either due to the trend being in place for a long time or because the last trending movement was so strong it made the price advance or decline a large distance which they assume means the trend is definitely going continue traveling in the same direction.

image of shallow pullback

Here we have a shallow pullback which formed at the end of a long down-move on AUD/USD.

This shallow pullback took place after the market had made a large move lower which means there would have been a large number of retail traders placing short trades even when the shallow pullback was taking place. The fact the market had been in decline even before this last move lower only further adds to the retail traders belief that the market is set to continue falling.

Note:

The bank traders still buy/sell to make the market move in the direction of the trend on shallow pullbacks only the trades they place are much smaller than what they would place if a deep pullback took place or a 50% pullback, the smaller the distance the market manages to retrace during a pullback the smaller the trades the bank traders are able to place as not enough orders will be present in the market.

image of shallow pullback on eur/usd

The image above is an example of a shallow pullback which forms after the market suffers a steep decline.

By the time the pullback above forms the price has dropped a significant distance in a relatively short amount of time, in the previous image we had a steep decline and the price had been dropping for quite a while before the shallow pullback formed, in this image the price has not been falling for a long time but the size of the drop itself is enough to make retail traders believe the down-move is certain to continue.

When market begins to move against the down-move the retail traders are still placing short trades as they think the market is still going to move lower, the sell orders which are coming into the market from these traders are being used by the bank traders who are causing the shallow pullback in the first place to take more and more profits off their own sell positions which they placed before the down-move itself began.

image of bullish movement

Take a look at the far right of the chart, this is the type of movement which will make retail traders believe the market is sure to carry on moving higher.

Notice how its constructed of multiple bullish large range candlesticks ?

These are same candlesticks traders use to identify strength in the market, when traders see these candles they assume the movement is strong is likely to continue in the same direction.

image of large bullish move with shallow pullbackWhen the banks start taking profits of the buy positions they had placed before the large move higher it consumes all the buy orders from the retail traders and the price begins to fall.

Ultimately it will always be the banks who cause the market to reverse in a shallow pullback situation, the main point is the price will not be able retrace a large distance because most retail traders in the market will still believe the price is going to continue in the direction of the swing in which the shallow pullback is taking place. It makes no sense for the banks to place sell trades and push the market lower when lots of retail traders are buying because they can end up making more profits by pushing the price higher.

Additionally depending on the size of the buy trades placed by the banks before the move up, they may not have enough retail traders buying to take the amount of profits they wish to take off their trades, therefore they need another move higher to take place just so they can close out the rest of their trading position.

 

What Do Shallow Pullbacks Teach Use About The State Of The Market

 

As a trend increase in length more and more traders will become aware of its existence, eventually the trend will reach a point where it has moved in the same direction for such a long time that traders just assume it’s going to continue forever, this means any movement the traders see against the trend will be seen by them as an opportunity to get into a trend which they believe is certain to continue.

What this means is seeing a shallow pullback form after a long trending move tells us a lot of retail traders are likely to be trading in the direction of trend, which is a warning sign to us the trend may be coming to an end.

Retail traders will typically identify a trend taking place in the market when the trend itself is nearing the end of its life.

When they see a trend they’ll all decide to buy or sell at the same time which causes a large move in the direction of the trend, this is the point where a shallow pullback has the highest probability of occurring as the influx of orders form the retail traders will be used by the banks to take massive profits off their existing trading positions.

By the time the retail traders have entered into the trend the profit on the bank traders trades are huge, so in order for them to be able to close these trades and actually make the majority of profit their trades have generated they need lots of retail traders to be placing trades in the direction of the trend.

Even though a shallow pullback is the smallest ( in terms of size ) of the pullbacks which can take place in the market they are the pullbacks in which the bank traders will usually be taking the biggest of the profits off their trades.

You wouldn’t think it looking at the shallow pullback itself because of the distance the market manages to retrace into the last swing, all the other pullbacks which retrace past the 38.4% level make it seem like the bank traders are taking more profits as the price is closing deeper into the swing.

But with the shallow pullback only a small retracement occurs so it doesn’t look like a lot of profit taking is taking place when really the reality is bank traders are taking the majority of their profits on the shallow pullbacks because so many retail traders are placing trades in the direction of the trend, which means their profit taking does not cause a large retracement as there are so many opposing orders from the retail traders absorbing all of their take profit orders.

 

Summary

 

Shallow pullbacks can be a great indicator of the strength of the current trend/movement in the market, their appearance late into a move signals to us that a large number of retail traders may now be trading in the direction of the trend which could be an early indication of the current trending movement coming to an end.

Both the shallow pullback and the deep pullback are the two most important pullbacks which can be seen in the market, they are the only pullbacks which can give us knowledge as to how the traders are participating in the current trend, the other pullback ( the 50% retracement ) can not provide us with much information as to what trades believe about the future price direction which means we should focus primarily on shallow pullback and deep pullbacks.

 

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2 comments

  1. Phil

    Hi,
    Just wanted you to know the link in the article doesnt work. Its regarding the link in the 1st paragraph named ‘understanding pullbacks’.

    Best Regards,
    Phil

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