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Trade Articles

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Disclaimer: The views on the posts and charts are for educational and illustration purpose only, as past performance is not necessarily indicative of future performance. They are provided for general information only and therefore should not be taken as any offer or solicitation to do any investment or trade.

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A Retracement or Reversal?

By Hector in Trade Articles on 16 October 2019

A Retracement or Reversal?

Do you know the difference between a retracement or a reversal?

How many times have you sold your shares and it went up higher without you on board? One of the frustration of traders and investors is selling a big winner too early and failing to ride the trend higher. To help solve the problem and increase your winning rate, the key is to know whether the stock is in retracement or reversal.

A retracement is a temporary price movement against the primary trend. In a primary bullish trend, a secondary retracement will be bearish. Conversely, in a bearish primary trend, a retracement will be bullish.

On the other hand, a reversal is a change in the primary trend in the price direction. When the primary uptrend changes to a downtrend, a reversal occurs. Conversely, when the primary downtrend changes to an uptrend, a reversal occurs.

Below charts shows the difference between a retracement and reversal.

 

Retracement Or Reversal

 

Retracement

 

An uptrend price movement does not move up in a straight line. The market can become tired moving in the same direction after a period of time.

In an uptrend, when the price goes up too high in the time frame that you are trading, buying pressure run down after a while as there is no new buyer to push the asset price higher.

When the demand falls, price will begin to go lower. As prices drop to a lower attractive level such as a support level, new buyers who have previously missed the opportunity step in to create demand. Subsequently, the price begins another swing higher which ends the retracement phase.

Retracements or pullbacks described above is healthy in a primary uptrend or downtrend. They are opportunity times to enter new position or add tiers to existing position.

 

Reversal

Unlike retracements, reversals represents a larger change in the direction of the price actions. They are often caused by fundamental reasons such as earnings, new products, contract win /loss, etc.

Back to the previous uptrend scenario where prices drop to a lower support level and new buyers step in to buy.

For a reversal, the counter trend is not temporary. As prices retrace, sellers will take the opportunities to offload more assets into the market and prevent it from going higher. As supply is more than demand now, prices will drop. When price go even lower than the previous low, more sellers jump on the bandwagon to sell and cause price to drop further.

Reversal can be difficult to track even for the experienced traders to react. This is because, in the early stages of a reversal and in the absence of a drastic price action, the price of the asset may still shows indication of a continuous move in the primary trend.

So, how do you know whether it is a retracement or reversal? Below are some clues you can use to help you to tell the difference between a retracement or reversal:

 

Factors

Retracement

Reversal

1.Volume

Small volume trades (Profit taking by retail traders)

Large block trades by Institutions

2.Time Frames

Last 1-2 weeks (Short term correction)

Last more than 2 weeks

(Longer term reversal)

3.Fundamental

No Change in fundamental

Change in fundamental (Likely reason for reversal)

4.Occurrence

Usually after a large gain

Anytime, during normal trading , news or results.

5.Chart Pattern

Few reversal patterns

Many reversal patterns

 

 

How to identify Retracement or Reversal?

In price action trading, we can employ 3 methods to help us identify a retracement or a reversal.

 

Method 1: Fibonacci Retracement Levels

 

Fibonacci retracement levels are great tools to measure the extend of a retracement . To use them, we use the Fibonacci retracement tool found in our charting software to draw a line from the top to the bottom of the swing.

 

Fibonacci Retracement

 

Usually, the stronger the trend, the smaller the retracement will be. A retracement can pullback near the 38.2% or 50% levels before continuing the prevailing trend. However, if the price moves beyond the 61.8% level, there is a high probability that a reversal may be forming.

In POEMS Mercury, you can find the Fibonacci retracement tools in the chart shown below:

 

Poems Mercury Fibonacci Retracement

Method 2: Swing Pivots

Another method to see if price is forming a retracement or reversal is to use swing pivots.

 

Swing Pivots

 

In a downtrend, price will swing from a high to a lower high and a low to a lower low. These are swing pivots that forms the horizontal support and resistance levels.

On the other hand, in an uptrend, price will swing from a high to a higher high and a low to a higher low to form the support and resistance levels

In a retracement, an asset price may not be able to push to a higher high and pullback occurs. Now, so long as the pullback is not swinging to a lower low, the primary uptrend is still intact. It may continue to push above the previous high after the retracement.

However, when the correction is moving towards the previous low and a lower low is established as a result, the uptrend is over and a reversal may be forming.

 

Method 3: Trend lines

 

The final method is to use the trend lines.

Reversal

 

A primary trend line is constructed by joining two pivot points. In a downtrend, we join two swing high pivots to form a downtrend line. On the other hand, in an uptrend, we join two swing low pivots to form an uptrend line.

When the primary trend line is broken, a reversal may be forming. Notice the word ‘may’? There will be times when there will be false trend line broken or false breakout and you need to be aware and expect it.

 

Conclusion

 

Being able to identify and distinguish the difference between a retracement and reversal can reduce the number of losing trades and increase the probability of winning trades.

When you read your charts and see that the price is making a counter trend move, the first thing you need to do is to identify whether it is a retracement or reversal and take the appropriate plan and actions accordingly.

While everybody want to ride a a new trend from the beginning, new traders are advised and encouraged to trade retracements with the primary trends. To trade reversals may require more experience and psychological strengths which takes time to build up.

 

Happy Trading
One Good Trade

 

 

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