What is a 'Retracement'
A retracement is a temporary reversal in the direction of a stock's price that goes against the prevailing trend. A retracement does not signify a change in the larger trend. On a chart where a stock's price is generally headed upward, retracements are the small dips in price that the stock experiences during its overall upward trend.
BREAKING DOWN 'Retracement'Whether an investor identifies a change in a stock's direction as a retracement or a reversal will impact how he responds to it. A retracement can be positive or negative in direction as long as it is the reversal of the prevailing trend. For example, if a stock’s price experiences an upward movement from $10 to a peak of $30 that may be considered part of a growth trend. If the same stock then falls to $25, it is still well above the starting price of $10. In this case, the shift from $30 to $25 would be considered a retracement if the price then continued along the aforementioned growth trend. If the price continued to fall from $25, returning to the previous low of $10, it may be considered a reversal instead of a retracement as all previous gains associated with the growth period have been lost.
Technical Analysis and Retracements
Technical analysts make an important distinction between retracements and reversals as retracements are short-term changes within a longer-term trend, while reversals indicate the end of a larger trend and the beginning of a new trend. When a retracement first begins, it is difficult to tell whether it is a retracement or a reversal as a retracement does not have a defined time period to complete. Technical analysts try to distinguish between the two using Fibonacci retracements, pivot point support and resistance levels, and trendline support and resistance levels.
Investment Tactics During Reversals and Retracements
While a true reversal away from a growth trend may indicate the associated stock should be sold in order to prevent significant losses, a retracement can actually signal a time to buy. This is due to the fact that since the lower prices are considered temporary this retracement period may allow an investor to purchase additional shares at a lower cost than previously. If the stock was truly experiencing a retracement, the investor will experience gains on the newly purchased shares when the retracement ends.
The risk in this technique is that there is no guarantee that a retracement, and not a reversal, is occurring. As with all investment analysis, there are no guarantees that a method used to predict a stock’s movement will ultimately be accurate.