What’s the difference between retracements and reversals?

Even experienced investors have been sucked into bad trades when a price decline looked like the start of a long-term trend but turned out to be just a hiccup. If you’ve ever sold a stock only to see it climb a few hours or days later, or bought only to see it drop, you’ve probably confused retracements and reversals. At their most basic definitions, a retracement is simply a temporary reversal in the context of a larger trend, while a reversal is a complete change in the direction of a trend that lasts for a significant period of time. In the chart below, the uptrend began slowly and quickly gained momentum; despite the retracements, the overall trend continued in the same direction. Specifically, the price climbs to new highs, and even when it drops during a retracement, it rallies before hitting the prior low. These are hallmarks of retracements within an upward trend. When the reversal occurred, the downward trend was accompanied by several rapid retracements in which the price briefly rallied without ever returning to the prior high. Some key characteristics that differentiate a retracement from a reversal include:
  Retracement Reversal
Movement Passive, hesitant Aggressive, lots of movement and momentum
Trade volume Low Typically spikes
Duration Short Long
Candlesticks “Indecision” candles with long tops and bottoms, spinning tops, doji Engulfing, abandoned baby, harami, stars, hammer, hanging man
Precursors Typically after large gain None, happen seemingly at random
  The question all traders want to know, however, is whether the movement is a slight pullback, a deep retracement, or the start of a complete reversal. This is where divergence comes in. If the chart shows divergence across multiple timeframes, a reversal is likely. If there’s no divergence, it likely represents pullback from a retracement. One final “tell” that a retracement is about to become a full-blown reversal is when the trendlines supporting the broader trend are broken on high volume. Trendlines combined with candlesticks often confirm a reversal pattern. Nothing is foolproof, however—a textbook retracement can quickly become a reversal with few warning signs. Stop loss orders are the best protection against unexpected movement. There are two ways to do this:
  • Use a Fibonacci calculator to estimate retracement levels and place a stop-loss just beyond that price point, or
  • Place a stop-loss just below the EMA as an exit strategy.
  EMAs are also helpful in differentiating between retracements and reversals. Generally, a price bounce at 21 EMA is a shallow pullback, and a bounce at 144 represents a deep retracement. A reversal generally occurs when the 21 EMA crosses the 144 EMA. Ultimately, the point is to keep you from prematurely exiting a trade during a retracement without hindering your ability to quickly exit a reversal.