Retracement

What Is Retracement?

In technical analysis, a retracement refers to a temporary and partial reversal of a financial asset's price within a larger, established market trend. It represents a natural pause or correction in the prevailing direction before the original trend is expected to resume. For instance, in an uptrend, prices generally move higher, but a retracement would see prices briefly pull back before continuing their upward ascent. Similarly, in a downtrend, prices move lower, and a retracement would involve a short-lived bounce upward. Retracements are often considered healthy market behavior, allowing a trend to consolidate and gather momentum rather than indicating a full trend reversal. Traders and analysts use retracements to identify potential entry or exit points, often looking for these temporary pullbacks to buy into an existing uptrend or sell into a downtrend, typically near anticipated support or resistance levels.

History and Origin

The concept of observing and interpreting temporary price movements within larger trends is deeply rooted in the origins of technical analysis itself. While not explicitly termed "retracement" in early literature, the foundational ideas came from pioneers like Charles Dow in the late 19th century. Dow's work, which laid the groundwork for Dow Theory, recognized that markets move in primary, secondary, and minor trends. Secondary reactions, as he described them, were essentially counter-trend movements that would retrace a portion of the primary trend, similar to what is now understood as a retracement.¹⁹, ²⁰ Early technical analysts, or "chartists," meticulously drew trend lines and patterns by hand to discern these temporary pullbacks and distinguish them from full trend changes.¹⁸ Major market events throughout history, such as the sharp decline in October 1987, have often been followed by periods of partial recovery, demonstrating the real-world occurrence of these price movements.¹⁶, ¹⁷

Key Takeaways

• A retracement is a temporary price pullback within a larger, ongoing market trend.
• It signifies a short-term counter-movement rather than a complete change in the primary trend direction.
• Retracements are often seen as healthy market consolidations that allow the primary trend to recharge.
• Technical analysts commonly use tools like Fibonacci retracement levels to predict the potential extent of a retracement.
• Identifying retracements can help traders find opportune moments to enter or exit positions in line with the dominant trend.

Formula and Calculation

Retracements are typically measured as a percentage of a prior price move. The general formula to calculate the percentage of a retracement is:

For an uptrend (price moved up, then retraces down):

For a downtrend (price moved down, then retraces up):

Where:

• Prior High = The peak price reached before the retracement began.
• Prior Low = The trough price before the upward move or the lowest price reached during a significant down move.
• Current Low = The lowest price reached during a downward retracement within an uptrend.
• Current High = The highest price reached during an upward retracement within a downtrend.

While this provides a general percentage, analysts often use specific ratios, most notably those derived from the Fibonacci Retracement sequence (e.g., 23.6%, 38.2%, 50%, 61.8%, 78.6%) to anticipate common retracement levels. These percentages are not arbitrary but are based on mathematical relationships observed in natural phenomena and financial markets.

Interpreting the Retracement

Interpreting a retracement involves assessing whether the temporary price movement is likely to continue against the main trend or if the original trend is about to resume. Analysts observe the depth and duration of the retracement. A shallow retracement that quickly finds a support level (in an uptrend) or resistance level (in a downtrend) and resumes the original direction is often seen as a sign of strength in the underlying trend. Deeper retracements, especially those approaching or exceeding the 50% or 61.8% Fibonacci levels, might suggest that the trend is weakening or that a full reversal could be imminent.

Furthermore, traders combine retracement analysis with other price action signals. For example, if a retracement reaches a key Fibonacci level and then forms a bullish candlestick pattern, it could be interpreted as a strong signal for the original uptrend to continue. Conversely, a bearish pattern at a retracement high in a downtrend would reinforce expectations for further declines. The volume accompanying a retracement can also provide clues: lower volume during a retracement often indicates that the temporary counter-move lacks strong conviction, supporting the idea that the primary trend will persist.

Hypothetical Example

Imagine a stock, "GrowthCo Inc.," has been in a strong bull market for several months. Its price rose from an initial low of $100 to a recent high of $150. This represents a $50 upward move.

Suddenly, GrowthCo Inc. experiences a pullback. Its price drops from $150 to $130 before stabilizing. This $20 decline ($150 - $130) is the retracement.

To calculate the retracement percentage:

• Prior High (peak before retracement) = $150
• Prior Low (start of the major upward move) = $100
• Current Low (lowest point of the retracement) = $130

Using the formula for an uptrend retracement:
(\text{Retracement Percentage} = \frac{\text{Prior High} - \text{Current Low}}{\text{Prior High} - \text{Prior Low}} \times 100%)
(\text{Retracement Percentage} = \frac{$150 - $130}{$150 - $100} \times 100%)
(\text{Retracement Percentage} = \frac{$20}{$50} \times 100%)
(\text{Retracement Percentage} = 0.40 \times 100%)
(\text{Retracement Percentage} = 40%)

In this hypothetical example, GrowthCo Inc. experienced a 40% retracement of its previous $50 upward move. A technical analyst might then compare this 40% retracement to common Fibonacci Retracement levels. Since 38.2% and 50% are common levels, a 40% retracement would suggest that the pullback is within a normal range and that the underlying uptrend is likely to resume.

Practical Applications

Retracements are a fundamental concept in trading strategy and are applied across various financial markets, including stocks, forex, and commodities. Traders often use retracements to identify optimal entry points during an ongoing trend. For example, a common approach is to "buy the dip" in an uptrend, waiting for a price action to retrace to a significant support level or a key moving average before initiating a long position.¹⁵

Conversely, in a downtrend, traders might "sell the rally," looking for the price to retrace upwards to a resistance level before opening a short position. The concept of a market "pullback" or "correction" which are types of retracements, is frequently discussed in financial news and analyst reports, particularly after periods of rapid gains.¹², ¹³, ¹⁴ For instance, market strategists may warn clients to prepare for a "pullback" as valuations appear stretched, suggesting that a temporary reversal is overdue.¹⁰, ¹¹ These anticipated pullbacks, while potentially painful in the short term, are often viewed as normal and healthy for the long-term sustainability of a market trend, allowing the market to "recharge" before continuing its primary direction.⁷, ⁸, ⁹

Limitations and Criticisms

Despite their widespread use, retracements and technical analysis, in general, face several limitations and criticisms. One primary challenge is distinguishing a genuine retracement from a full-fledged market correction or trend reversal. What appears to be a temporary pullback can sometimes evolve into a significant downturn, leading traders who "buy the dip" to incur substantial losses. This ambiguity necessitates combining retracement analysis with other technical indicators and confirming signals.

Another criticism stems from the efficient market hypothesis (EMH), which posits that financial markets are efficient and that asset prices fully reflect all available information.⁴, ⁵, ⁶ Under this hypothesis, past price movements, including retracements, cannot be reliably used to predict future price movements, thus rendering technical analysis ineffective for consistently generating abnormal returns.³ Critics argue that the apparent success of retracement strategies might be due to self-fulfilling prophecies, where enough traders act on the same levels, or simply due to chance. Some academic studies and analyses question the efficacy of technical analysis, suggesting that it doesn't consistently outperform simpler investment strategies.¹, ² Furthermore, market volatility can make retracement patterns less clear, increasing the risk management challenges for traders relying solely on these patterns.

Retracement vs. Reversal

While often confused, a retracement and a reversal represent distinct market phenomena.

The key difference lies in whether the counter-trend movement is expected to continue or eventually give way to the original trend. A retracement maintains the integrity of the dominant trend, while a reversal negates it and establishes a new primary direction. Identifying which is occurring can be challenging for traders, requiring careful observation of price action, volume, and other confirming indicators.

FAQs

What causes a retracement?

Retracements are typically caused by profit-taking by traders, temporary shifts in sentiment, or natural market consolidation after a significant price move. They can also occur as prices approach key resistance (in an uptrend) or support (in a downtrend) levels.

Are all pullbacks retracements?

Not all pullbacks are necessarily retracements. A pullback is a general term for any decline in price, while a retracement specifically refers to a temporary and partial pullback within an established trend that is expected to resume. A deeper, more prolonged pullback might indicate a market correction or a full trend reversal.

How do traders use retracements?

Traders primarily use retracements to identify potential entry points for trades in the direction of the larger trend. For example, in an uptrend, they might wait for a retracement to buy at a lower price, anticipating the original upward move to resume. They also use them to place stop-loss orders or set profit targets.

What are common retracement levels?

While a retracement can be any percentage, technical analysts often pay close attention to Fibonacci Retracement levels such as 38.2%, 50%, and 61.8%. These percentages are derived from the Fibonacci sequence and are widely observed in financial markets as areas where prices tend to pause or reverse.

Can retracements be predicted?

While the exact timing and depth of a retracement cannot be predicted with certainty, technical analysts use various tools and historical patterns to anticipate potential retracement levels. These include Fibonacci levels, moving averages, and prior support and resistance zones. These tools provide probabilities rather than guarantees.