What Is a Retracement?
A retracement is a when a stock rises or falls versus a trend. The chart below is of General Electric Co. (GE), and it is showing that the stock is in a downtrend. However, there are points on the chart that indicate that the price is rising, which would be considered a retracement.
- A short term change of a trend followed by the continuation of the previous trend.
- It is not the same as a reversal.
What Does a Retracement Tell You
A retracement by itself does not say much, but when combined with other technical indicators it can help a trader identify if the current trend is likely to continue or if a significant reversal is taking hold. It is essential to determine the difference between a reversal and a short-term retracement.
Example of How To Use a Retracement
A retracement is not easy to identify, because it can easily be mistaken for a reversal. Even worse is if a reversal is mistaken for a retracement. The chart below shows the S&P 500 during 2018 when a significant uptrend took place between April and October. There are three retracements identified on the chart, although there were a series of smaller ones as well, as the S&P 500 was rising to record highs. What is most important is that the retracements never breached the uptrend. However, in October what appeared to be a retracement became a reversal after the index did finally fall below the uptrend, leading to a sharp decline.
The Difference Between a Retracement and a Reversal
Again, it is important to remember that a retracement is a minor or short-term pullback in the price of a stock or index. But what is key is that the stock does not breach a critical level of support or resistance nor does it breach the uptrend or downtrend. Should the price fall or rise above support or resistance, or violate an uptrend or downtrend, then it is no longer considered a retracement but a reversal.
Limitations of A Retracement
A retracement should not be used alone; it should be used in conjunction with other technical indicators. If not used correctly, it could cause the analysis to be misguided.