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.

Retracement

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.

Chart showing uptrend with retracements

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.

trend reversal on price chart using price action and trendlines
Trend Reversal on Price Chart. Investopedia 

The chart shows the asset's price moving in an uptrend as it makes higher highs and higher lows. The price falls below the trendline and makes a lower low as it drops. The asset makes pullbacks but continues in the downward trend. Once the price begins to make higher highs and lows again, it will signal a reversal to the upside.

Special Consideration

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)
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) Reversal candles – these include engulfing, soldiers and other similar patterns

As you look through the table above, remember that short interest is delayed when reported, so it can be difficult to tell for certain depending on your time frame.

The chart above can be summarized by saying retracements have an abundance of indecision in their movements, and reversals display authoritative actions. Volume may be low on a pullback but spikes on a reversal. The former is passive; the latter is aggressive. Higher lows and higher highs characterize retracements in an uptrend, while reversals are often characterized by patterns that are contrary to this, such as double tops—two similar highs and then a new low—or head and shoulder patterns—lower high followed by a lower low. Even the short-term movements reflected by individual candlesticks are often more hesitant during retracements, while the candles that form when an uptrend reverses are typically very long with lots of movement and momentum.

So, why is recognizing retracements so important? Whenever a price retraces, most traders and investors are faced with a tough decision. They have three options:

  1. Hold throughout the sell-off, which could result in large losses if the retracement turns out to be a larger trend reversal.
  2. Sell and re-buy if the price recovers, which will unquestionably result in money wasted on commissions and spreads, and may also result in a missed opportunity if the price recovers sharply.
  3. Sell permanently, which could result in a missed opportunity if the price recovers.

By properly identifying the movement as either a retracement or a reversal, you can reduce cost, limit losses and preserve gains.

Determining Scope

Once you know how to identify retracements, you can learn how to determine their scope.

Fibonacci Retracements are excellent tools for calculating the scope of a retracement. 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.

2:22

Fibonacci Retracement

Retracements between 23% and 78% of the prior impulse wave are common. That does not mean the stock falls 23%. Instead, it means that, if stock recently moved from $10 to $5, it will often retrace at least 23% of that $5 move—or $1.15. At this point, the trend is still up, assuming $15 was a new high and $10 was the recent low. If the price bounces higher above $10, then the uptrend is still intact, if it rallies and makes a new high. If it doesn't move above $15 and starts to fall again, it may be time to get out.

Pivot point levels are also commonly used when determining the scope of a retracement. Since the price will often reverse near pivot point support and resistance levels should the price continue past this point it indicates a strong trend while stalling and reversing means the opposite. Pivot points are typically used by day traders, using yesterday's prices to indicate areas of support resistance for the next trading day.

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.

The following chart shows this in action. A downtrend is in place, but then price rallies above the trendline. At that point, the price had already made a higher low. Following the breakout, there is a small retracement, but then the price pushes higher on strong volume. This movement is no longer a retracement in a downtrend, rather the wave up has reversed the downtrend, and the trend is now up.

Chart showing trendline reversal with trading

Dealing With False Signals

Even a retracement that meets all the criteria outlined in the table above may turn into a reversal with very little warning. The best way to protect yourself against such a reversal is to use stop-loss orders.

Ideally, you want to lower your risk of exiting during a retracement, while still being able to exit a reversal promptly. Steeping away takes practice, and it is impossible to be right all the time. Sometimes, what looks like a reversal will end up being a retracement, and what looks like a retracement will end up being a reversal.

As a trader, differentiate between retracements and reversals. Without this knowledge, you risk exiting too soon and missing opportunities, holding onto losing positions, or losing money and wasting money on commissions/spreads. By combining technical analysis with some basic identification measures, you can protect yourself from these risks and put your trading capital to better use.

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.