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PR09 - Trend Retracement or Reversal?

"The markets, as you might know move in a zig zag fashion. It is very rare to see price move in a parabolic fashion. This zig zag movement of price is something called retracements in the markets. Price tends to retrace as it corrects itself over a period of time, while maintaining the prevailing trend. As a result, retracement strategies are quite commonly used in trading. But besides trend retracements, there is something else called trend reversals. Unlike a retracement, where the previous trend direction is maintained, with trend reversals, the trend direction changes completely. What this means is that while traders expect price to move in the direction of the previous trend, price ends up reversing direction completely. This can lead to a significant shift in the trading bias and potentially have a few losing trades as the stops are triggered. So what is trend retracement and what is trend reversal? We cover these two aspects of the markets in this article."

Trending following is perhaps one of the most widely followed methods of trading the forex markets. Trend following, as the name suggests is all about positioning yourself in the direction of the trend.

But trend following or trending markets doesn’t mean that the markets will move in just one direction. By forces of supply and demand, price tends to move around in a zig zag fashion as it continues to build up on the trend.

This zig zag fashion is also known as corrections or retracements in a trend. For example, if price is moving in a steady uptrend, you can expect it to correct. In other words, price moves in the opposite direction and retraces a part of this trend.

One of the major problems for traders is that a retracement looks exactly similar to a trend reversal. A trend reversal, as the name suggests is when the trend reverses direction. This can happen when the price shifts course and starts to move in the opposite direction.

Trend retracement and reversals are therefore often used interchangeably. It is important to understand that in real time, as the markets evolve, there is no way of telling if the markets are retracing or reversing the trend.

This information can only be applied in hindsight.

You can already see the problem facing traders here. If you are a trend trader, then it makes sense to trade when a retracement is completed. This allows you to enter the market right after a correction.

But how does one know if this retracement is indeed a retracement and not a reversal? For example, after price retraces and then starts to rise up again, you might think that the retracement is complete.

Price is after all reversing course and moving in the same direction of the trend which it did before. But what if price then starts to continue to retrace? At some point you will have to acknowledge that a trend reversal has taken place.

Can you identify trend retracements and trend reversals?

One way to overcome the confusion between trend retracement and trend reversals is to make use of indicators. A retracement is usually a small counter trend move in price. For example, if pricing is in an uptrend but then retraces to the opposite direction, you should expect price to reverse and continue the uptrend.

But with reverals it is the opposite. Price initially starts off as a retracement, only to continue in this same direction.

PR09 01 Retracement Reversal

Trend retracement v/s trend reversal


In the above chart, you can see an illustration of the trend retracement and trend reversal. Notice that they initially look the same, at least until the retracement bit (the first red arrow, sloping down).

However, with trend retracement, you can see that the previous uptrend is resumed, depicted by the rising green arrow pointing up. This is a trend retracement at work and soon the uptrend is resumed.

Now, looking to the right side, the trend reversal initially looks the same as the trend retracement. But in this case, after the completion of the retracement, price fails to breakout higher from the first high.

Instead, you can see a lower high being formed and then price eventually breaks past the first retracement point as well.

This is nothing but trend retracement and trend reversal in play.

How to trade trend reversals and trend retracements?

There is no straight forward answer to this. Generally, retracements are traded by identifying support and resistance levels. Traders also prefer to use the Fibonacci retracement tool in order to identify potential levels where price has a high probability of retracements.

For trend reversals, traders can look to the oscillators which can signal in advance a potential retracement that could take place. You can also make use of trend based indicators such as moving averages or Bollinger bands to identify when a trend is likely to retrace.

It is important to note that only after the retracement will you be able to understand if it is indeed a retracement or actually a reversal in play. Therefore, you need to be very careful. There is a good chance that your positions could get stopped out if there is a trend reversal taking place.

By combining one or many of the above methods outlined, traders are able to easily distinguish trend reversals and trend retracements. One of the biggest determining factor is that traders need to be patient when it comes analyzing such a phenomenon. This is something that takes practice but sooner than later, you would be able to identify trend reversals and trend retracements.

Read 1217 times Last modified on Sunday, 14 July 2019 08:21