Identifying when a change in trend is occurring is one of the most important skills a trader can learn. There are several methods that can be used to identify a possible change in trend; however, one of the easiest to spot is the emergence of a new pivot point. While identifying a pivot must always be done in hindsight, one can examine clues on a chart to determine whether the probability of forming a new pivot is high. One technique is to watch for a partial retrace after a trading range has been established.
When a stock refuses to honor an established range, it usually reverses to break the trading range in the opposite direction, thus establishing a new pivot point. By picking a bottom, a trader can benefit by getting in early on a new trend. In this article we will discuss concepts from a long (uptrend) perspective and using stocks as the financial instrument. For shorting, apply the same concepts in reverse. These concepts will work for any instrument that can be charted, as they simply measure the psychology of the market participants.
Identifying a Partial Retrace
There are three basic trends for stocks: uptrend (moving higher), downtrend (moving lower) and consolidation (moving sideways). A stock in an uptrend is defined as making higher pivot highs, and higher pivot lows.
|Figure 1: A downtrend and an uptrend|
|Figure 2: Sideways trend|
|Copyright supply or demand triumphs. Typically, the trend prior to the consolidation is continued; however, there is always the possibility of a reversal. (To learn more, read Retracement Or Reversal: Know The Difference, Market Reversals And How To Spot Them and Support And Resistance Reversals.)
Beating a Breakout
Trading a Partial Retrace
While there is no way of knowing whether the stock is pausing or reversing until after it happens, the use of other tools in your technical toolbox can provide areas likely to provide support for a partial retrace. Examples would be moving averages, Fibonacci sequences, Bollinger Bands® or gaps. A calculated risk can be taken as long as tight risk management is employed. Typically, the second higher daily high after a decline of several candles into such support is enough to confirm your thesis of a reversal. This would place the buy at 3.85 for WPTE with a stop about $0.10 lower. (For more insight, check out Exploring Oscillators And Indicators.)
WPTE attempted to break out a week later and was ultimately rejected by the previous trading range. Nonetheless, buying the partial retrace netted a 15% gain in a week. It should be noted that it's not a bad idea to take profits at resistance due to the increased risk of buying in a base. As sellers were waiting at this established resistance area, excess supply began to force WPTE to drift back into the trading range after the failed breakout. Buyers returned in late January and early February at the same partial retrace area established earlier. While there were several false buy signals, it started becoming clear that WPTE was under accumulation in late January. The buy was a little over 3.80 again with a stop well under the partial retrace at 3.54.
WPTE rocketed past resistance shortly thereafter, completing the breakout. Once it cleared the trading range, the trend changed to an uptrend. Notice the higher pivot highs and lows marked on the chart. WPTE was up over 50% in four weeks and it remained an open trade.
XING was making lower highs and lows (marked by the red arrows) throughout the latter part of 2006. Things changed in early 2007 as XING began making higher highs and lows (shown by the green arrows) after making a partial retrace. It was a partial retrace because it refused to make a lower low, which was the established trading range. Why were we looking for a partial retrace in this area? If you look toward the tail end of December, you will notice a gap higher that remained unfilled. Typically, gaps hold as support moving forward; this increased the odds that XING would complete a partial retrace in this area. XING continued to move higher quickly until it stumbled in late February.