How does one tell what qualifies as a correction inside a bigger trend and what is the start of a trend reversal? Depending on who you are talking to, and their aggressiveness and skill as traders, you might get as many answers as you can count.
With this in mind let’s look at one of the most natural ways of deciding: price making a lower low in a downtrend (as is the case with my weekly USDCHF chart) or a higher high in an uptrend. To use the weekly USD/CHF downtrend example: using closing prices of the weekly bar, wait for the current bar to close under the previous significant lowest close (it does help if the current bar’s low is also lower than the previous lowest low). You can then project a likely target for the down move. Measure the size of the correction (dark rectangle), and from the 50% line you can plot a price projection (light gray rectangle).
This projection “trick” is something learned from seasoned traders and tends to have a high success rate that can frequently be translated into pips. Simple is often better.
We have determined that a new low has been made, and constructed our charts in order to see where the projected target is going to be, but what if the price moves in our direction and fails to reach the desired target? This happens from time to time. When it does, one should be prepared to close the trade and perhaps even reverse the position because this sort of bounce will more often than not push in the opposite direction and reach the other side of the pattern.
The need to be aware of where price is in the bigger picture is very important, as the accompanying EUR/JPY chart shows. On the weekly chart (small insertion on lower left corner of daily chart) the correction and its target have been established and the pair is trading nicely inside the pattern, while on the daily chart a failure to reach the initial target shows that no pattern is 100%. If price action touches the secondary daily target at 117.40, that can be a strong sign that we will reverse and head towards the weekly target at 103.50.
This supports the notion that trading in general, and trading with only price action in particular, is very discretionary, and one should be prepared at all times to adapt when patterns fail.