Why Do Deep Pullbacks Occur In The Forex Market ?

Today I thought we would look in more detail as to why deep pull-backs occur in the forex market.

Pullbacks themselves can reveal a wealth of information on what is going on behind the scenes in the market. For example, if the market only manages to pullback a small distance into a swing it can be a sign that a large number of traders are now trading in direction of the trend, which could be an early indication of the trend itself coming to an end.

Analyzing deep pullbacks can give us clues as to what the large institutions are doing in the market, if you understand why deep pullbacks take place you can determine with a certain degree of accuracy which direction the market is going to move in and how far its going to move in one direction.

I’ll explain all of these concepts to you throughout the article and I’ll also show you how to determine if a deep pullbacks is taking place in the market using the 76.4% fibonacci level.

 

 

What Are Deep Pullbacks ?

 

In simple terms, a deep pullback is when the market make a pull-back deep into an up or down swing.

They are most commonly seen at trend reversals but there are times when you may see one form during trends. Overall if you have a firm grasp on how the market works in terms of how people place trades, close trades etc, deep pullbacks are one of the most informative pieces of market structure you can see on your charts.

Not only can they help you predict a reversal, they can also give you some idea as to how big the reversal is going to be, depending on how big the deep pull-back itself is. (more on this later)

One of the most obvious features of a deep pullback is the way it will make you think the market is going to move in the direction of the preceding movement.

image of deep pullback on 1 hour chart of eur/usd

Take a look at the far right hand side of the image where I’ve marked the three arrows.

If you were watching the move down on your charts its likely you be thinking the market is going to drop lower and the bullish pullback was simply just the first pullback in the new down-move.

image of fibonacci retracement on eur/usd chart

But wait a minute ? Look what’s happened now……

The down-move has failed, and the market has moved up. What we have here is a classic example of a deep pullback

If you thought the down-move was a continuation of the downtrend then you are not alone. Thousands of other traders thought the same, the majority of these traders would have placed sell trades under the impression the market was going to drop lower.

When it failed to do so and instead began moving up, all of the traders who went short had to close their sell trades as they were losing money. The way deep pullbacks make large numbers of traders go either long or short is what makes them so important for finding out key information about the market.

You’ll see later how large institutions use deep pullbacks to get big trading positions placed into the market, and why which time-frame you see the deep pullback form on has a direct effect on the size of the reversal it will create.

 

How To Detect Deep Pull-backs

 

Deep pullbacks are easily visible if you have spent a large amount of time watching the markets. Once you know how deep pullbacks are defined it will be easy for you to spot them on your charts.

A defining characteristic of a deep pullback is the way the pullback will end near one of the extremes of the swing your observing…..

If you see a downswing a deep pullback will end towards the swing high, for an upswing it will end near the swing low.

In a situation where you are not sure if what you’re seeing is a deep pullback or something else, the Fibonacci retracement tool can be used to quickly identify if a deep pullback is in fact taking place.

You may remember in my article on Fibonacci trading a couple of the images I used to explain how retracements work contained a fifth level which I didn’t give you any information about. The fifth level doesn’t appear with the default settings on the Fibonacci tool so when you place a Fibonacci retracement grid on your charts the fifth level will not appear.

I’m going to give you a quick guide now on how to add the fifth level to your charts.

 

The 76.4% Retracement Level

The easiest way to see a deep pullback is to add the 76.4% level to your Fibonacci tool.

image of 76.4% retracement on usd/jpy

Here we have a retracement grid with the default levels drawn on.

To add the 76.4% level to the grid you need to left click on the red dotted line drawn from the swing high to the swing low in the example above.

Note:

Some people may need to double-click on the dotted line as their MT4 settings could be different from mine.

Once you have double clicked the line right-click on the line and a small box should appear, find where it says Fibo Properties and left click, a new box should open up….

image of fibonacci setting on mt4

Now click on the Add button, a new level should be created with a zero in it, double-click on the zero and type in 0.764

Aviary Photo_131034798104246144

Once you’ve done that, move over to the description box and type in 76.4, it should look the same as what I’ve put in the box above.

Click OK and the 76.4% level should appear on your Fibonacci grid….

image of full fibonacci grid on usd/jpy

And there you have it, now you can use the 76.4% Fibonacci level to easily spot deep pullbacks in the market. If you ever need to add other retracement levels onto the Fibonacci grid follow the process outlined above.

Why The 76.4% Level Is Good At Finding Deep Pull-Backs

 

As I revealed in my Fibonacci article the market itself does not move due to it hitting Fibonacci levels, anyone who tells you otherwise whether it be online or in books is either lying or simply does not know how the forex market really works. The only way for the market to move is by people placing trades, if the market falls to a Fibonacci level and proceeds to move up the reason it’s moved up is because the bank traders had enough orders in the market to place their own buy trades.

Even though Fibonacci levels themselves cannot cause the market to move the levels are still helpful for traders who need a visual method for identifying which pullback is currently taking place in the market.

It’s important to note the 76.4% level isn’t some special level which only I’ve discovered.

It just a way to show us the point where the majority of traders will believe the deep pullback is a continuation of the previous trend.

Really you could plot any Fibonacci level between the 70% and 90% ratios on your chart and all of them would show you a deep pullback taking place, the reason I use the 76.4% level is its close to the beginning of when the traders who are placing trades onto the deep pullback will believe the pullback is a continuation of the previous movement whether it be up or down.

The 61.4% level whilst being close to showing us a deep pullback is not as powerful as seeing the market pullback to the 70% level and beyond.

When it comes to finding deep pullbacks in the market stick to using the 76.4% level rather than the 61.4% level.

 

Why Do Deep Pullbacks Occur ?

 

The sole reason a deep pullback takes place in the marker is due to bank traders wanting to get as many retail traders as possible placing trades in the wrong direction. Usually you’ll see deep pullbacks occur at the beginning of trend reversals, the reason you mainly see them take place here as opposed to during a trend is because of professional traders wanting to get as many trades placed in the direction of the reversal before the new trend begins.

A deep pullback has the effect of making large numbers of traders believe the previous trend is continuing, the best example of this taking place is the start of the USD/JPY uptrend.

image of bank traders placing buy trades at beginning of usd/jpy uptrend

When retail traders think the previous trend is going to continue they’ll place trades in the direction of the deep pullback, this allows the professional traders who want to get trades placed in the direction of the reversal to place buy trades as he now has a large amount of orders coming into the market from the traders selling expecting the deep pullback to continue in the direction of the previous trend.

 

The Size Of The Deep Pullback Predicts The Size Of The Reversal

 

If there is one way to predict where the market is going to go and how far it is going to go this is it…..

How big a deep pullback is determines how far the market will travel once it reverses.

I guess the question now is……. “How do you determine if a deep pullback is big or not”?

Well its simpler than you may think, a big pullback is one which the majority of traders in the market can see, a deep pullback on the 5 minute chart is not considered big as only the traders on the 5 minute chart will think the deep pullback is a continuation of the previous trend.

image of deep pullback on 5 minute chart of usd/jpy

Here’s a deep pullback on the 5 minute chart of USD/JPY.

The traders on here will look at the large move up and believe the market is going to begin trending higher, when the market drops and begins moving higher again they think it’s just a pullback to the previous up-move, they start buying expecting the market to make a new higher high.

Additionally there will be a large percentage of traders buying on the 1 minute chart, if we were to look at the deep pullback  on the 1 min chart (which we can’t because my MT4 isn’t working properly) it would look like a large uptrend is taking place to the traders trading the 1 minute time-frame, meaning they will place buy trades under the impression the trend is going to continue.

I wonder how the deep pullback looks to the higher time-frame traders ?

image of deep pullback on 30 minute chart of usd/jpy

Here’s what the pullback looks like on the 30 minute chart.

The traders using this time-frame can’t even see a deep pullback taking place, all they see is a bullish candlestick. If the traders on the 30 minute chart can’t see a deep pullback none of the traders on the time-frames above can see the deep pullback either. Therefore we only have traders on the 1 minute – 5 minute and possibly 15 minute time-frames placing trades onto the deep pullback movement, which means when the deep pullback ends, and the market begins moving back in the direction of the trend, only three sets of traders are likely to be closing their trades at a loss.

image of start of usd/jpy uptrend

Compare that with the deep pullback seen at the start of the USD/JPY uptrend, where everyone on the weekly chart and below would have been selling on the pullback as it looked like a continuation of the previous downtrend, then you can see how the larger the deep pullback is in terms of how high a time-frame it appears on, the more traders who will be placing trades in the direction of the deep pullback itself, which in turn means the higher the number of traders who will be closing losing trades when the pullback ends.

So the bigger the deep pullback is the more traders who will be either going long or short depending on the previous trend, if all these traders are placing trades in the direction of the pullback then when the market reverses and begins going in the other direction the traders will be put at a loss on their trades, eventually their loss will become so big that they have to close their trade, when they close their trade more orders will be put into the market which will push the market in the direction of the reversal.

In the USD/JPY example the majority of traders were going short as they believed the deep pullback was a continuation of the previous downtrend, when the market began moving higher the short trades the traders had placed went from being at a profit to being at a loss, so they started closing their trades. The only way to close a short trade is buy buying, therefore the short traders are putting a massive amount of buy orders into the market, causing the price to advance and in essence causing the reversal.

When it comes down it the size of the reversal a deep pullback will create depends on two things:

  1. How long the prior trend has been in place before the deep pullback forms.
  2. How big the deep pullback itself is, the higher the time-frame you see the deep pullback on the higher the number people who will be placing trades in the direction of the deep pullback.

By analyzing both of these conditions you will be able to determine with a relatively degree of certainty how big a reversal from a deep pullback will be and also the size of the movement which follows a deep pullback.

Summary

 

Deep pullbacks are some of the most important events which take place in the market, when you see a deep pullback you know something big is taking place behind the scenes which could have a dramatic effect on market direction.

Hopefully with the concepts I’ve given you in this article your now able to better understand why deep pullbacks occur and what they can mean for the future market direction, if you have any questions or comments about today’s article please leave them in the comment section below.

 

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