Table of contents
How annoying it is when the cost of a pair you were trading keeps increasing and increasing. But just as you’re about to enter the trade at this high price point, it starts dropping lower and lower.
This is a typical scenario where people get into and are unsure what they could have done to make the trade profitable. We will examine trend retracement and reversals to identify which is which and how one can benefit from them.
In trading, it is crucial to understand the difference between market retracements and reversals. This article will look at these two things, giving traders knowledge about how to recognize and handle different movements in the market. Now, we will go into the details of retracement vs reversal and what sets them apart from each other.
Understanding market trends
Market trends are the common path or direction in which the price of an asset is going. Traders label these as upward (bullish), downward (bearish) and sideways (range-bound) trends.
Higher highs and higher lows, which represent more market trust, are the traits of an upward trend. Lower highs and lower lows show that people’s faith in the market is decreasing. When there is not much movement either way, this is called a sideways trend. It can mean either uncertainty or consolidation in the market (flat). These ideas hold significance, as they help to know how to identify retracement and reversal.
What is a trend retracement?
Retracements, also called pullbacks or dips, are just temporary price reversals that happen within the trend of a currency pair. These occur frequently and are part of the trading environment. Traders often get tricked by charts that seem ready for a reversal but find out too late they have entered a retracement situation. Specific individuals eager to enter a trade might think they have discovered a reversal and are prepared to exploit it.
But, they might only be observing a retracement, and their trade could begin to move opposite swiftly.
What is a trend reversal?
When an uptrend turns into a downtrend or becomes an uptrend, we see what is called a “reversal.” One technique to decrease your risk as you examine reversals and retracements is by employing trailing stop loss. This aids in allowing you to stay on the present trend in your currency while also reducing your risk.
Trailing stop loss keeps on moving in the direction of the currency as it works for you. So, you won’t ever take additional risk beyond what was initially set when making this stop-loss order. But if a trend happens to be caught by it, then your profit potential can become significant.
You will be stopped if you are wrong, and it’s a retracement instead of a reversal. But, the loss on your trade will be minimal.
Comparison between reversal and retracement
The difference between retracement and reversal are as follows:
| Aspect | Reversal | Retracement |
| Definition | Indicates a significant change in the direction of a trend, often leading to a new trend formation. | Represents a temporary reversal in the prevailing trend, followed by a continuation of the original trend. |
| Duration | Typically, it lasts longer and results in a more sustained change in market direction. | Usually shorter in duration and does not lead to a complete change in market direction; the original trend resumes after a brief pause. |
| Magnitude | It involves a substantial shift in price direction, often accompanied by high trading volumes. | Involves a moderate price movement against the prevailing trend, usually within a predetermined percentage or Fibonacci retracement level. |
| Significance | It is considered a significant market event, potentially indicating a shift in investor sentiment and long-term trend direction. | Viewed as a minor correction within the context of the broader trend, traders often use it to identify entry points for trend continuation trades. |
| Impact | It can trigger major market movements and significant changes in market psychology, leading to new market trends. | Typically, it has a limited impact on market sentiment and trend direction, temporarily pausing or correcting the prevailing trend. |
What should you do?
When faced with a possible retracement or reversal, you have three options:
- If you are in a place, you might hold it. This can bring losses if the retracement becomes a long-lasting reversal.
- You may select to close your position and re-enter if the price starts moving with the overall trend once more. Indeed, there is a chance for missed trade if the price sharply moves in one direction. Additionally, money gets spent on spreads when you decide to re-enter.
- You can also close permanently. This may result in a loss (if the price action reversal and retracement went against you) or a significant profit (if you closed at the top or bottom), depending on how your trade is structured and what happens afterwards.
Because reversals can happen anytime, choosing the best option isn’t always easy.
This is why applying trailing stop loss points can successfully manage risk in trend trading.
It helps safeguard your profits and ensure that you always leave with some pips in case of a long-term reversal.
Why is it necessary to distinguish between retracement and reversal?
If seen as a reversal, a retracement could result in significant losses. Having clear recognition of both helps one measure possible short-term and medium-term benefits. A retracement can give the trader a chance to make small profits or let them join into a more significant uptrend. However, if one can identify a reversal well ahead of time, it could offer an even more significant opportunity.
Retracements offer a chance to join a trade that was missed, whereas reversal means a total alteration in the existing sentiment. Recognizing a proper reversal makes traders’ decisions more valuable and enhances their confidence in trading. To identify retracement and reversal, one needs to create another trading model.
Factors that help in identifying retracement and reversal
Retracement comes from different parts, with Fibonacci retracement being recognized most often. It highlights the percentages where a stock can retrace and display bounce back. The levels of 23.6%, 38.2%, 50%, 61.8% and 78.6% are the primary retracement levels to consider when analyzing a stock.
Moving averages also have a notable part. It could show a possible reversal if the short-term moving averages are combined with the long-term average.
The volume also shows a clear picture. A sharp rise or swings in volumes give the first sign of reversal, and if it keeps on for some more sessions, one can look for weakness in the stock.
The daily chart might not give enough clarity, so we must study weekly and monthly charts to clarify doubts.
The bottom line
As a trader, you must recognize the distinction between retracements and reversals. Not having this understanding might lead to three possible scenarios: exiting at an incorrect time, thus missing out on opportunities, holding onto positions that are losing money or experiencing losses due to wrong directional bets and wasting both money from commissions/spreads and trading capital. By using technical analysis and some basic identification steps, we can safeguard ourselves against these dangers and better use our funds for trading purposes.
FAQs
A very common method to locate retracements is by employing Fibonacci levels. Price retracements tend to pause near the 38.2%, 50.0% and 61.8% Fibonacci retracement levels before resuming the primary trend. If the price surpasses these ratios, it could indicate a change in direction.
RSI, MACD, Bollinger Bands and Fib Retracement or Support and Resistance are the technical indicators you can apply to identify a trend reversal from an intraday or short-term trading perspective.
Moving averages are used to smooth out price fluctuations and identify trends. A common indication of a trend change is when the short-term moving average crosses over or under the long-term moving average.