What is retracement?

Retracements are a small movement away from the overall direction of a price. They are temporary in nature and do not reflect a wider market trend. While, over a certain period of time, the value of an asset might rise or fall overall, it very rarely does so consistently. 

For instance, the price of a stock might go up by 10% overall over the course of a day, but there might be times when it dips slightly. Those dips are called retracements, and understanding the retracement definition is key to understanding trading. 

Recognising retracements is a crucial part of understanding a price chart and how an asset’s price behaves over a period of time. 

Highlights

What causes retracements?

Retracements happen for a variety of reasons. If the market is going up potential buyers might feel, at least for a time, that the price is too high and they should wait for it to settle down before taking advantage. 

It could also be that significant buyers have already done most of their buying, and may be waiting to come back in at a lower price. People might also decide that they have made enough of a profit to sell, at least in the short term. 

The reverse things may also be true if the retracements are upward movements during a downward trend.

The Fibonacci sequence starts 1,2,3,5,8,13,21,34,55 and continues ad infinitum, with each number being the product of the two preceding numbers. If you want to find the next Fibonacci point of any number in the pattern, you multiply it by 1.61 if you want to go up, or by 0.61 if you want to go down. 

What’s significant about this is that markets have a tendency to reverse the direction they’re going in at various points on the scale. In percentage terms, the magic number is 61.8%. 

So, let’s draw six lines on a chart. The first is the highest point an asset has reached over a given time period, representing 100%, the second at 61.8%, the third at 50%, the fourth at 38.2%, the fifth at 23.6% and the final one, 0%, at the lowest point of price movement. 

They are all Fibonacci numbers, barring 50%, and they have a tendency of being, roughly, where retracements tend to take place.

Knowing when a market trend is about to hit a fibonacci point, or using a fibonacci technical analysis indicator can help us predict a potential retracement, although nothing is certain. Traders might take advantage of believing a retracement might happen by either buying or selling the asset before the retracement takes place. 

Keep in mind that if it moves too far, and for too long that it is not a retracement but, potentially, a reversal. Talking of such matters, what is the difference between the two?

Retracements vs reversals

It is important to understand that there is a difference between a retracement and a reversal. With a retracement, the price will move away from the general direction of movement but will, ultimately, continue along with the trend. 

With a reversal, however, the change in direction is significant and breaks through the levels that the asset’s price has been hovering between – to use the technical term, the support and resistance – to create a new paradigm. 

Reversals might often look like a retracement when they start, but they eventually become something different and bigger. It can be hard to tell the difference between a retracement and a reversal at first but, eventually, a reversal will continue and take things to another level, while a retracement will see the price go back to its original trajectory soon enough. 

Traders who use a range of technical analysis instruments, perhaps most notably the fibonacci system, might be in a better position to predict whether a recent price change is a retracement or the start of a reversal.

However, technical analysis tools cannot predict the future. Therefore, it is best to act with a degree of caution when making decisions based on technical analysis as prices can move in a way that damages your position.

Retracements are similar to pullbacks and the two words are often used interchangeably. If we are being precise, though, pullbacks only apply when talking about brief downward movements during an upward trend, whereas retracements can go both ways. 

It might be useful to think of it like this: all pullbacks are retracements, but not all retracements are pullbacks.

How to trade retracements

Some traders specialise in trading using retracements, taking advantage of the fibonacci points mentioned above. This strategy does involve a lot of work and is often unsuccessful, so it is important to be careful.

In conclusion, retracements are small market movements away from the overall trend which are soon reversed as the asset price continues in the direction it was going in. If the reverse motion continues for any length of time, or if it moves too far, then it is a reversal, which is another matter.

While traders may be able to try to predict when a retracement will take place using a variety of tools, most notably the fibonacci system, markets can be very unpredictable. Therefore, it is important to do your own research, remember that prices can move in a direction that can damage your position, and never trade with more money than you can afford to lose.

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