Many times traders who observe a drop in price of an asset want to know whether this decline is a long-term one or it is just a temporary short-term movement. Why? Well, some traders would prefer to sell a stock before it continues to decline in price over a long time period but would rather wait over a temporary down shift if the price will get back on track reaching new highs soon; the opposite may be true for buy positions. Identifying which one of the scenarios you are dealing with can help to largely improve your performance.
What is a trend reversal?
A reversal happens when the price of an asset changes direction of movements and continues in that direction for a relatively long period of time. Reversals can happen for many reasons, for example major change in market fundamentals, large volume institutional sale or purchase or any other major market change; reversals are typically accompanied by ‘reversal’ candles. A reversal in a price trend creates higher highs or lower lows within the time frame.
How to identify a reversal?
eToro offers several instruments that may help you to identify a trend reversal. Usually tools like trend lines and moving average indicators are useful in spotting price reversal points. For example, when the price falls below the MA line there is a potential for a downward price reversal, like on the image below, and vice verse for an upward reversal.
The chart above shows the stock moving into an upward direction with higher highs and higher low price levels over a relatively long time period. However, as some point the price drops below the moving average trend line with a lower low price level. The price makes small upward pullbacks but the overall trend continues downwards, indicating a point of a downward trend reversal. Once the price chart breaks from downward and moves upwards again, there is a signal of an upward reversal. As a day trader you might consider daily price reversals, but if you are trading over longer time horizons you may choose to focus on price reversals over weeks, months or even quarters: time period of a reversal depends on its relevance to your trading time frame. Ignoring a trend reversal may lead to excessive risk taking and unexpected losses in your trading process.
What is a retracement?
A retracement or a trend ‘pullback’ is a short-term reversal in the direction of a price that takes place within a general long-term trend. These changes are temporary and do not mean that the main larger trend will be reversed. Retracements can be caused by changes in money flow, for example change in the buying interest of market participants during a decline or an uprise, market indecisiveness, change in trading volume when retail traders take profits in small block trades and so on; they usually coincide with ‘indecision’ candles on a price chart.
How to identify a retracement?
You can identify a retracements using a basic tool of trend lines. When there is downtrend, you can draw the trend line by connecting several (at least 3) lower high levels, with the price bouncing away from the trend line, to identify retracements.
In an uptrend you can identify retracement by connecting the preceding low to the previous high price levels. You can then use this indicator to identify buy and sell signals. A buy signal can be inferred from the price reaching Fibonacci support level during an upward trend and a sell signal when Fibonacci resistance is reached during a downward trend.
You can also use Fibonacci retracements indicator available on eToro; this indicator consists of multiple lines that indicate potential support and resistance with levels as values taken from the Fibonacci sequence. Retracements are then likely to occur at levels that correspond to 38.2%, 50.0% and 61.8%. There is a possibility of a trend reversal when the chart reaches levels beyond 100% on the indicator.
It can be quite challenging to immediately spot whether the change in the direction of a price trend is a retracement or a complete reversal. A trader needs to remember that pullbacks are only temporary and in these conditions the price should not surpass the critical support and resistance levels: as soon as it does, it may be considered a reversal. In case you are unsure which one of the two is about two happen, using trailing stop-loss option offered by eToro may be a good idea for efficient risk management. You can also choose to:
- Hold your position, although this may lead to potential losses in case an actual reversal is happening.
- Close position for some time and re-open when the trend is back on track, although this may lead to potential lost opportunities.
- Close the position permanently, although this could also lead to potential losses or profits, if the position was closed at the right time.
Ultimately, the choice depends on your ability to interpret indicator signals, degree of risk-aversion and general trading skills.
Hopefully now you have a better understanding of what price reversals and retracements are and how they can affect your trading process. Remember that trading involves capital loss risks, beware of misinterpreting indicator signals and enjoy trading on eToro. Best of luck!
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