What's the Difference Between Retracement and Reversal? (2024)

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 pullbackbut 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 headand 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 lossesand 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 most recent price swing or impulse wave.

Retracements between 23% and 78% of the prior impulse wave are common. That does not mean the stock falls 23%. Instead, it means that the stock price drops 23% of the distance of the two points being measured by the retracement tool. For example, if you using a Fibonacci retracement tool to measure the retracement of an upward move from 10 to 15, you might find the tool showing you $13.45 as the first retracement level. That's because a 23% retracement would be found by multiplying the difference: $5.00 x .23 = $1.15. The 23% retracement would be $1.15 lower from the high point, so the tool would mark $13.85.

At this point, the trend is still up, assuming $15was 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 $15and 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 nearpivot 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 resistancefor 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.

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.

The Bottom Line

As a trader, you must learn to differentiate between retracements and reversals. Without this knowledge, you risk exiting too soon and missing opportunities, holding onto losing positions, orlosing money and wasting money on commissions and 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.