Retracements and reversals
Most people fall into the trap called retracements thinking they are reversals when they are not. Retracements are merely short-term or temporary movements that the price makes opposing the formed trend.
To put it is more straightforward, this is an occurrence where the price moves against the formed trend but goes back later on.
On the other hand, a reversal is when a price moves totally against the overall price trend. So when a price moves against the formed downtrend to the point that it becomes an uptrend: that is a reversal. The same is true with established uptrends. If the price moves against the uptrend to the point that It becomes a downtrend: that is a reversal.
Let us cite an example.
For instance, the price started to decline. Later on, it is still falling. However, it had a sudden increase for some time. What do we know? It began to decline again. What we have here is not a price action rally but a smooth retracement. It might not be a pleasant experience, but unfortunately, it can happen to any trader. It would have been a reversal if the price did not start to rise again, but it did — making it a smooth retracement.
Some traders often get mistaken with retracements as reversals, leaving them having lousy trading decisions. Some fail to see the picture and ride the established trend long enough since they got confused with the two.
How do we handle such situations?
We have curated some advice for you if you found yourself in a situation where you doubt if you are looking at a reversal or only a retracement. You have three choices:
- Choice 1: Hold on to your position if you are in one. Since you are not sure if it is just a retracement or a reversal, if it turns out that it is a long-term reversal, then you might have to say goodbye to your expected profits and say hello to losses.
- Choice 2: Close your position for the meantime and enter again as soon as the price moves in the same direction as the formed trend. This option has a few downsides. One is that you can miss out on great trading opportunities if the price moved sharply in a single direction. Another is more spread expenses when you enter the trade again.
- Choice 3: Close the position for good. This option has two sides of the coin. Depending on the situation, you can go home with your hefty profits if your close is on the top or bottom. You can also end up having losses if the price moved against your favor. It all depends on your trade and what happens next.
Some reminders before closing the topic
It might be hard to know what is best if you find yourself in such situations. Reversals and retracements are unpredictable. They can always happen anytime and to anyone. However, there are trailing stop-loss to back you up when you are trading in trending markets.