Retracement vs. Reversal: What’s the Difference?

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Retracement vs. Reversal: What’s the Difference?

Retracement vs. Reversal: An Overview

Most of us have pondered if a drop in the price of a stock we own is long-term or just a market blip. Some of us have sold stock in similar circumstances, only to watch it surge to new highs days later. This is a frustrating and all-too-common circumstance. While it cannot be completely avoided, if you understand how to recognize and trade retracements correctly, you will see an increase in your success.

Key Takeaways

  • Retracements are transitory price reversals that occur within the context of a bigger trend.
  • Higher lows and higher highs describe retracements in an uptrend.
  • A trend reversal occurs when the trend reverses.
  • When there is a reversal, the price is likely to remain in the reverse direction for a lengthy period of time.
  • Contrary patterns, such as double tops, are often used to identify reversals.

Retracement

Retracements are transitory price reversals that occur within the context of a bigger trend. The important thing to remember is that these price reversals are just transitory and do not signify a change in the overall trend.

Despite the retracements, the long-term trend seen in the chart below remains intact. The stock price continues to rise. When the price rises, it establishes a new high; when it falls, it starts to rebound before hitting the prior low. This movement is a tenet of an uptrend, which has higher highs and lower lows. While this is happening, the tendency is upward.

Only when an uptrend makes a lower low and lower high is the trend called into question, and a reversal may be occurring.

Image by Sabrina Jiang © Investopedia2020

Reversal

A reversal, on the other hand, occurs when an asset’s price trend switches direction. It suggests that the price is likely to stay in that reverse direction for a long time. These directional adjustments might occur to the upside after a downward trend or to the downside following an upward trend.

The most common adjustment is a significant price change. However, there might be pullbacks in which the price returns to its original direction. It is tough to identify whether a momentary price adjustment is a pullback or the continuation of a reversal right away. The transformation might occur suddenly or gradually over days, weeks, or even years.

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Moving averages (MA) and trendlines assist traders in identifying reversals. Day traders are interested in intraday reversals, whereas long-term funds or investors may be interested in developments over months or quarters. When the price falls below the MA or a drawn trendline, traders know to look for a possible reversal, as indicated in the graphic below.

Image by Sabrina Jiang © Investopedia2020

The chart depicts the asset’s price moving in an upward trend, with higher highs and lower lows. As it decreases, the price falls below the trendline and sets a lower bottom. The asset has pullbacks but maintains its downward trend. When the price starts to make higher highs and lows again, it will indicate an upward reversal.

Special Considerations

It is critical to understand the difference between a retracement and a reversal. When identifying a price change, you should consider many major distinctions between the two.

Distinguishing Retracements from Reversals
FactorRetracementReversal
VolumeProfit taking by retail traders (small block trades)Institutional selling (large block trades)
Money FlowBuying interest during declineVery little buying interest
Chart PatternsFew, if any, retracement patterns– usually limited to candlesSeveral reversal patterns– usually chart patterns (double top)
Short InterestNo change in short interestIncreasing short interest
Time FrameShort-term reversal, lasting no longer than one to two weeksLong-term reversal, lasting longer than a couple of weeks
FundamentalsNo change in fundamentalsChange or speculationof change in fundamentals
Recent ActivityUsually occurs right after large gainsCan happen at any time, even during otherwise regular trading
Candlesticks“Indecision” candles– these typically have long tops and bottoms (spinning tops)Reversal candles– these include engulfing, soldiers and other similar patterns

Remember that short interest is delayed when reported, thus it might be tough to discern for definite depending on your time period when you go at the chart above.

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The chart above may be summarized by noting that retracements have a lot of hesitation in their movements, whilst reversals have a lot of authority. Volume may be modest during a retreat, but it increases with a turnaround. The first is passive, whereas the second is aggressive.

Retracements in an uptrend are defined by higher lows and higher highs, but reversals are generally marked by patterns that contradict this, such as double tops—two comparable highs followed by a new low—or headandshoulder patterns—a lower high followed by a lower low. Individual candlesticks’ short-term movements are normally more reluctant during retracements, but candles that emerge when an uptrend reverses are often quite lengthy with plenty of movement and velocity.

So, why is it so vital to recognize retracements? When a price retraces, most traders and investors are forced to make a difficult choice. They have three choices:

  1. Hold during the sell-off, which might result in significant losses if the retracement proves to be a wider trend reversal.
  2. If the price rebounds, sell and re-buy, which will undoubtedly result in money spent on fees and spreads, as well as a lost chance if the price recovers significantly.
  3. If the price rebounds, selling permanently may result in a wasted opportunity.

You may cut costs, limit losses, and preserve profits by correctly classifying the movement as a retracement or a reversal.

Determining Scope

You may discover how to assess the breadth of retracements after you’ve identified them.

Fibonacci Retracements are great for estimating the extent of a retracement. Draw a line from the top to the bottom of the most recent price swing or impulse wave using the Fibonacci retracement tool, which is included in most charting software.

Retracements of 23% to 78% of the preceding impulse wave are typical. This does not imply that the stock has dropped 23%. Instead, it signifies that the stock price has fallen by 23% of the distance between the two points assessed by the retracement tool. For instance, if you use a Fibonacci retracement tool to calculate the retracement of an upward move from 10 to 15, the program may display you $13.45 as the first retracement level. This is due to the fact that a 23% retracement would be discovered by multiplying the difference: $5.00 x.23 = $1.15. The 23% retracement would be $1.15 lower than the peak point, putting the tool at $13.85.

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Assuming $15 was a new high and $10 was the previous low, the trend is still up at this point. If the price rises over $10, the uptrend will continue if it rallies and sets a new high. If it does not rise beyond $15 and begins to decrease, it may be time to go.

When defining the extent of a retracement, pivot point levels are also widely employed. If the price continues through the near-pivot point support and resistance levels, it suggests a strong trend, whilst halting and reversing shows the opposite. Day traders usually utilize pivot points to predict regions of support and resistance for the following trading day, based on yesterday’s pricing.

When important trendlines that support the overall trend are broken on high volume, a reversal is most probable. To confirm reversals, chart patterns and candlesticks are often utilized in combination with these trendlines.

The graph below illustrates this in action. A downtrend exists, but price then rises above the trendline. The price had already struck a higher low at that moment. Following the breakthrough, there is a little pullback, but the stock immediately surges higher on heavy volume. This movement is no longer a downtrend retracement; rather, the wave up has reversed the downtrend, and the trend is now up.

Image by Julie Bang © Investopedia2020

Dealing With False Signals

Even a retracement that fits all of the conditions indicated in the table above might quickly turn into a reversal. Stop-loss orders are the greatest approach to protect yourself against such a reversal.

Ideally, you want to reduce your risk of departing during a retracement while still being able to escape quickly after a reversal. Steeping away requires practice, and being correct all of the time is impossible. What seems to be a reversal is sometimes a retracement, and what appears to be a retracement is sometimes a reversal.

The Bottom Line

You must learn to distinguish between retracements and reversals as a trader. Without this information, you risk losing money and squandering money on commissions and spreads by quitting too soon and missing out on chances, clinging onto losing positions, or losing money and wasting money on fees and spreads. You may protect yourself from these hazards and put your trading cash to better use by combining technical analysis with some simple identification methods.

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