Most of us have wondered, at some point, 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 our stock in such a situation, only to see it rise to new highs just days later. This is a frustrating and all too common scenario, but it can be avoided if you know how to identify and trade retracements properly.
What Are 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.
Figure 1 shows us an example of retracements in the price action of a particular stock:
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Notice that despite the retracements, the long-term trend shown in this chart is still intact - that is, the price of the stock is still going up.
The Importance of Recognizing Retracements
It is important to know how to distinguish a retracement from a reversal. There are several key differences between the two that you should take into account when classifying a price movement:
| Factor | Retracement | Reversal |
| Volume | Profit taking by retail traders (small block trades) | Institutional selling (large block trades) |
| Money Flow | Buying interest during decline | Very little buying interest |
| Chart Patterns | Few, if any, reversal patterns - usually limited to candles | Several reversal patterns - usually chart patterns (double top, etc.) |
| Short Interest* | No change in short interest | Increasing short interest |
| Time Frame | Short-term reversal, lasting no longer than one to two weeks | Long-term reversal, lasting longer than a couple of weeks |
| Fundamentals | No change in fundamentals | Change or speculation of change in fundamentals |
| Recent Activity | Usually occurs right after large gains | Can happen at any time, even during otherwise regular trading |
| Candlesticks | "Indecision" candles - these typically have long tops and bottoms (spinning tops, etc.) | Reversal candles - these include engulfings, soldiers and other similar patterns |
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So, why is recognizing retracements so important? Whenever a price reverses, most traders and investors are faced with a tough decision. They have three options:
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By properly identifying the movement as either a retracement or a reversal, you can reduce cost, limit loss and preserve gains.
Determining Scope
Once you know how to identify retracements, you can learn how to determine their scope. The following are the most popular tools used to do this:
- Fibonacci retracements
- Pivot point support and resistance levels
- Trend line support and resistance levels
Fibonacci Retracements
Fibonacci retracements are excellent tools for calculating the scope of a retracement. They are most widely used in the foreign exchange market, but are also used in the stock market. To use them, simply use the Fibonacci retracement tool (available in most charting software) to draw a line from the top to the bottom of the latest impulse wave. Figure 3 shows an example of this tool at work:
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In most cases, retracements will stay around 38.5% (daily) or 50% (intraday). If the price moves below these levels, then a reversal may be forming
Pivot Points
Pivot point levels are also commonly used when determining the scope of a retracement. Most traders look at the lower supports (R1, R2, R3) - if these are broken, then a reversal may be forming.
Trendline Supports
Finally, if major trendlines supporting the larger trend are broken on high volume, then a reversal is most likely in effect. Chart patterns and candlesticks are often used in conjunction with these trendlines to confirm reversals.
Dealing with False Signals
Even a retracement that meets all the criteria outlined in our table in Figure 2 may turn into a reversal with very little warning. The best way to protect yourself against such a reversal is to use stop-loss points. Here is how you can do this:
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Ideally, what you want to do is lower your risk of exiting during a retracement, while still being able to exit a reversal in a timely manner.
by Justin Kuepper
