What Is a Retracement?
A retracement is a technical term used to identify a minor pullback or change in the direction of a financial instrument, such as a stock or index. Retracements are temporary in nature and do not indicate a shift in the larger trend.
KEY TAKEAWAYS
A retracement is a minor pullback or change in the direction of a financial instrument, such as a stock or index.
The term, used by technical analysts to analyze the price of securities, refers to a short-term change in a stock’s price relative to an overarching trend.
Once a retracement is over, there should be a continuation of the previous trend.
Retracements are not the same as reversals—with the latter, the price of the security must breach support or resistance levels.
Understanding a Retracement
A retracement refers to the temporary reversal of an overarching trend in a stock’s price. Distinct from a reversal, retracements are short-term periods of movement against a trend, followed by a return to the previous trend.
The chart below illustrates the share price of General Electric Co. It is showing that the stock is in a downtrend. However, there are points on the chart that indicate that the price is rising, which would be considered a retracement.
A retracement by itself does not say much. However, when combined with other technical indicators it can help a trader identify if the current trend is likely to continue or if a significant reversal is taking hold.
A retracement should be used with other technical indicators and never alone. If not used correctly, it could cause the analysis to be misguided.
Retracement vs. Reversal
It is essential to determine the difference between a reversal and a short-term retracement. A retracement is not easy to identify because it can easily be mistaken for a reversal. Even worse is if a reversal is mistaken for a retracement.
The chart below shows the S&P 500 during 2018 when a significant uptrend took place between April and October. There are three retracements identified on the chart, although there were a series of smaller ones as well, as the S&P 500 was rising to record highs.
What is most important is that the retracements never breached the uptrend. However, in October what appeared to be a retracement became a reversal after the index did finally fall below the uptrend, leading to a sharp decline.
Again, it is important to remember that a retracement is a minor or short-term pullback in the price of a stock or index. What is key is that the stock does not breach a critical level of support or resistance nor breach the uptrend or downtrend. Should the price fall below or rise above support or resistance, or violate an uptrend or downtrend, then it is no longer considered a retracement but a reversal.