Retracement vs. Reversal: An Overview

Most of us have wondered whether a decline in the price of a stock we're holding is long-term or a mere market hiccup. Some of us have sold stock in such a situation, only to see it rise to new highs just days later. This scenario can be frustrating and all too common. While it can't be totally avoided, if you know how to identify and trade retracements properly, you will start to see improvement in your performance. I personally believe that this is just a healthy (AND NEEDED) retracement.

Retracements

Retracements are temporary price reversals that take place within a larger trend. The key here is that these price reversals are temporary and do not indicate a change in the larger trend.

Notice that, despite the retracements, the long-term trend shown in the chart below is still intact. The price of the stock is still going up. When the price moves up, it makes a new high, and when it drops, it begins to rally before reaching the previous low. This movement is one of the tenets of an uptrend, where there are higher highs and higher lows. While that is occurring, the trend is up.

It is only once an uptrend makes a lower low and lower high that the trend is drawn into question and a reversal could be forming.

Reversal

A reversal, on the other hand, is when the price trend of an asset changes direction. It means that the price is likely to continue in that reversal direction for an extended period. These directional changes can happen to the upside after a downward trend or the downside after an upward trend.

Most often the change is a large shift in price. However, there may be pullbacks where the price recovers the previous direction. It is impossible to tell immediately if a temporary price correction is a pullback or the continuation of the reversal. The change can be a sudden shift or can take days, weeks, or even years to materialize.

The moving average (MA) and trendlines help traders to identify reversals. Intraday reversals are important to day traders, but longer holding funds or investors may focus on changes over months or quarters. As shown on the image below, when the price drops under the MA or a drawn trendline, traders know to watch for a potential reversal.

Key Takeaways

Retracements are temporary price reversals that take place within a larger trend.
Retracements in an uptrend are characterized by higher lows and higher highs
A reversal, on the other hand, is when the trend changes direction.
With a reversal, the price is likely to continue in that reversal direction for an extended period.
Reversals are often characterized by patterns that are contrary such as double tops.

GOOD LUCK & CONTINUE TO HODL