What is a Retracement?
A stock market retracement is a temporary movement in the opposite direction of a current trend in price in the stock market -- in other words, when a stock that has been steadily rising experiences a brief decline, a retracement is in evidence. A retracement also occurs when a stock price that is moving downwards undergoes a short-term rise. The length of time that a retracement may last is generally no longer than a couple of weeks.
The Difference Between Retracement and Reversal
It is important to be able to distinguish between a stock market retracement, which is a temporary blip in the trend, and a reversal which is the end of one trend and the beginning of a trend in the opposite direction. When a retracement takes place, it is not a signal to close a position, and in fact, this may even provide a viable opportunity to increase the position along the lines of a pyramid trading strategy. A reversal on the other hand may indicate that it is time to exit a trade, and possibly take a trade in the opposite direction.
How to Indentify a Retracement or Reversal
To differentiate between retracements and reversals, there are a range of technical analysis tools which can provide indicators of which type of movement is being experienced. These tools include Fibonacci Retracements, Pivot Points and Candlestick Patterns. Using technical analysis, as well as a general study of certain aspects of the price movement can provide the best possible means of identifying whether a reversal is underway, or whether the movement is a retracement.
One indication of the nature of the movement can be found in the volume of trading. As a rule, a stock market retracement is accompanied by a low volume of selling, whereas a reversal is usually associated with a high volume of selling. Another sign can be found in the amount of buying interest, as there is generally a strong buying interest still present during a retracement, whereas in a reversal, the buying interest is low. Chart patterns can also provide information, and in a reversal, continuation patterns such as Wedges or Triangles are presented. A reversal will show chart patterns like Head and Shoulders or Double Top.
A Word of Warning
Being unable to differentiate between a retracement and a reversal may prove detrimental to a trader in the form of premature exits and missed opportunities, or staying in positions that should have been closed.
One thing to be aware of is that a retracement may become a reversal at any time, making it very important to have risk management strategies, such as a trailing stop loss, in place.
In Conclusion
While there are no guarantees in any trading scenario without the benefit of a crystal ball, using common sense, a solid trading strategy, and the appropriate technical tools, a savvy trader can navigate price movements successfully, whether these movements are short term retracements or long term reversals.