What is a 'Retracement'

A retracement is a temporary reversal in the direction of a stock's price that goes against the prevailing trend. For example, a retracement in an uptrend is a brief period of selling before the uptrend continues, also known as a dip.

Technical analysts closely watch for potential price retracements, and attempt to determine when the prevailing trend will continue by analyzing price and volume movements, areas of price support and resistance, and so-called Elliot Wave patterns experienced during its overall upward trend.Retracement

BREAKING DOWN 'Retracement'

A retracement should not be confused with a reversal, which is a change in the larger trend. A reversal of an uptrend, for example, begins a new downtrend.

However, when a retracement first begins, it’s often difficult to say whether it’s just a retracement, or the start of a trend reversal.

Technical analysis helps in this regard, especially the study of so-called Fibonacci retracements. This analysis is based on the so-called Golden Ratio, 1.618, or phi, identified by the Italian mathematician Leonardo Fibonacci. It appears in many disciplines including biology, art, and physics. This common ratio is found in the shape of pinecones, the growth of tree limbs, the shape of snail shells and even spiral galaxies throughout the universe.

The ratio also appears often in price-chart patterns and helps to identify potential price areas for reversals.

Modern software employed by technical analysts allows them to quickly find these potential reversal areas. First drawing a line with a computer mouse between the high and low of a prevailing trend then selecting the correct computer option quickly identifies all the Fibonacci ratios between the high and low, namely 23.6%, 38.2%, 50%, 61.8%, and 100%.

The most important of these is the 61.8% retracement, or the inverse of phi.

Often times, technical traders seek to buy or sell a stock that begins to go back to its prevailing trend at a retracement level, or sometimes buy more of a stock they already own, or sell more of a stock in which they are short.  

Others place stop-loss orders and prepare to exit a stock if it falls below a 61.8% retracement, believing at this point that the stock is in a new downtrend.

Pros and Cons of Retracements

Not every stock or market continues its prevailing trend once it reaches a 61.8% retracement. Using this retracement level on its own is not a powerful predictor of what price action follows next. Predicting the precise level where a trend will reverse generally is more difficult than trying to predict how far a trend may continue.

For this reason, technical analysts tend to look for retracements that also correspond with other technical indicators. For example, many also look for areas of price support near a golden ratio. A price level of support at which the stock often has traded in the past, identified using a price-by-volume chart, generally increases the confidence in the retracement signal.

In addition, all of the analysis above that also corresponds with the next sequence of a five-wave or three-wave Elliot wave generally increases a technical analysts’ confidence that a stock is in a retracement, rather than a new trend.

Even still, many also will incorporate stop-loss orders, in the event their analyses are incorrect.

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