Many of the most successful traders will only trade when there’s a trend present and some like to catch the new trend early on the reversal. Whatever the trading style, all traders need to know the difference between a trend retracement and a full-blown trend reversal. We’ve gone through some of the indicators, chart patterns and talked support and resistance already, but knowing retracement versus reversal is a must. Whether you’re looking to use Fibonacci, Moving Averages or Trend Lines as part of a trend following strategy, or looking for the reversal, then it’s worthwhile identifying whether the change in a trend is a correction or a complete turn-around.
Traders thus face the following dilemma:
- If they’re in a position relying on the trend continuing, do they hold onto their position? This could lead to losses if the retracement turns out to be a longer term reversal.
- They could close their position and re-enter if the price starts moving with the overall trend again. Of course there could be a missed trade opportunity if price sharply moves on. Money is also wasted on spreads if you decide to re-enter.
- They could close the position permanently. This could result in a loss (if price went against you) or a huge profit (if you closed at a top or bottom) depending on the structure of your trade and what happens after.
Because reversals can happen at any time, choosing the best option isn’t always easy. This is why using trailing stops can be a great risk management technique when trading with the trend . You can employ it to protect your profits and make sure that you will always walk away with some pips in the event that a long-term reversal happens.
Retracement or Reversal – The Difference
In a retracement or correction the long-term trend is still intact, so if you gambled on a full-blown reversal it could have been a costly trade. It’s important to know the difference between the two, as this will influence our decisions to hold, sell or buy the security with a view to picking it up later on.
A retracement is defined as a temporary price movement against the established trend. Another way to look at it is an area of price movement that moves against the trend but returns to continue the trend. Reversals are defined as a change in the overall trend of price. When an uptrend switches to a downtrend, a reversal occurs. When a downtrend switches to an uptrend, a reversal also occurs.
|Retracement or Reversal Check list||Retracement / Correction||Reversal|
|Volume||Small Selling Volume||Large Selling Volume|
|Money Flow||Buying Interest during decline is still present and selling interest in a up trend is still present||Buying interest is small in a down trend and selling interest is small in up trend. Both force price to reverse|
|Chart Patterns||Continuation Patterns (Wedges, Triangles, Flag & Pennant)||Reversal Patterns (Head & Shoulders, Double Top)|
|Time Frame||They are short lived||These are Longer Term movements|
|Fundamentals||No Change||Change or Speculation of change|
|Candlesticks||Lots of Indecision Candles with long shadows and small bodies||Reversal Candles lick engulfing, soldiers etc…|
This list is by no means fool proof, but give a trader a base for understanding the corrective nature of a market. Just remember to be aware of the time frame you’re dealing in. A weekly chart looking out 5 years may see a retracement, but that very same retracement may be a reversal on a daily chart – Remember time-frame analysis.
There are a few ways to identify retracements other than the checklist above. These are:
- Fibonacci Retracements
- Pivot Points
- Trend Lines
- Candlestick Patterns
1. Fibonacci Retracement
A popular way to identify retracements is to use Fibs. For the most part, price retracements hang around the 38.2%, 50.0% and 61.8% Fib level before continuing the overall trend. If price goes beyond these levels, it May signal that a reversal is happening. As you may have figured out by now, technical analysis isn’t an exact science, which means nothing certain…
2. Pivot Points
Another way to see if price is staging a reversal is to use pivot points (intra-day only). In an uptrend, traders will look at the pivot or lower support points (S1, S2, S3) and wait for them to hold or break. If broken, a reversal could be in the making! In a downtrend, traders will look at the pivot & higher resistance points (R1, R2, R3) and wait for it to hold or break.
The last method is to use trend lines. When a major trend line is broken, a reversal may be in effect. We’ve already looked at how to draw trend lines, how support and resistance can affect trend and how moving averages can act as trend lines, so if you’re unsure then please revisit the relevant section.
By using trend lines in conjunction with candlestick chart patterns discussed in Module 5, a trader may be able to get a high probability of a reversal.
3. Candlestick Patterns
You now have the tools to try to differentiate between a retracement and a reversal. Using the “Check List” and the “Identifying Retracement” section will give you a fighting chance. While these methods can identify the difference between retracements and reversals, they aren’t the only way. At the end of the day, nothing can substitute for practice and experience. With enough trading time, you can find a method that suits your trading personality in identifying retracements and reversals.
Reversals can happen at any time. Retracements can turn into reversals without warning. This makes using trailing stops very important. With trailing stops, you can effectively prevent yourself from exiting a position too early during a retracement and exit a reversal in a pinch.
Technical analysis is not an exact science and although these indicators and patterns can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you’ll be on your way to achieving this.
Ready to learn more? Check out this article on how to identify reversals.