What Is a Retracement?
A retracement is a word used in the financial markets to describe a temporary reversal in the trend of an asset like a stock or index.
Reversals are transitory and don’t signal a change in the underlying trend.
KEY POINTS
- A retracement describes a temporary reversal in the trend of a financial asset.
- Technical analysts use this word to describe a temporary deviation from an underlying trend in the price of a security.
- When a retracement ends, the prevailing trend should resume.
- The price of a security needs to break through support or resistance levels for it to be considered a reversal, which retracements do not constitute.
Grasping the Concept of a Retracement
When the overall trend in stock prices temporarily reverses, it is called a retracement.
A retracement is a temporary deviation from the trend that is followed by a resumption of the original direction.
The share price of General Electric Co. is displayed in the following chart. It indicates that the stock price is currently falling.
On the other hand, there are retracement points on the chart where the price is increasing.
Simply retracing your steps does not tell you anything much. When used in conjunction with other technical indicators, however, it can assist a trader determine if the present trend is likely to continue or whether a substantial reversal is taking place.
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Retracement vs. Reversal
Identifying a reversal from a mere short-term retracement is crucial. Because of its similarity to a reversal, a retracement is often misunderstood. Mistaking a reversal for a retracement is even worse.
The following chart details the performance of the GBP/USD.
The fact that the corrections never ended up crossing the uptrend line is crucial.
In October of 2018, however, the index of S&P 500 actually fell below the uptrend, triggering a strong downturn, turning what had seemed like a retracement into a reversal.
A retracement, it should be emphasized once more, is a tiny or temporary decline in the price of a stock or index.
The most important thing is that the stock price does not fall below or rise over a crucial support or resistance level, or break the trend.
If the price breaks through the level of support or resistance it has been trading near, or if it breaks the trend line that has been forming higher or down, we no longer have a retracement but a reversal.
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