Understanding when you are looking at a retracement or a reversal is a very important skill to have when you are working out how you will become a profitable trader.
The fact remains that most people set themselves up in a bad place if they don’t have this basic skill down pat. So, we wanted to look at how someone can spot a reversal in the trend.
Retracements vs. Reversals
One thing that you can do to try to save yourself some grief on the reversal versus retracement debate is to look for the tell-tell signs of what each one is and how they operate. Here’s a handy reference to help determine whether you’re looking at a retracement or reversal:
RETRACEMENTS
Typically occur after big price movements in one direction
Short-term move
The fundamentals of the market have not usually changed significantly
REVERSALS
Can happen at any time
Long-term change of direction
The fundamentals of the market have changed, which may be the reason for the reversal
Pivot Points
One tool that you can use to try to spot a reversal is pivot points.
In an uptrend, you will look for support points S1, S2, and S3 and wait for them to break. These are the points that should provide natural support even in an uptrend. Thus, if the support levels are broken through, then you may be spotting a reversal.
The same can be said in the opposite direction except that you would be looking at points of resistance in a downtrend — R1, R2, and R3. If they are broken, then a reversal may be actively happening now.
Fibonacci Retracement Lines
Retracements can be identified by using your Fibonacci retracement tool to see if the price movement is coming back up or down towards the 38.2, 50.0, or 61.8% retracement levels.
If the price moves towards one of those levels before reversing again, then you are likely looking just at a retracement and not anything more serious than that.
When the price breaks these levels and keeps going, then you may be looking at a reversal. Of course, there is nothing exact and precise about trading, so don’t assume that you have all of the answers. That said, breaking key Fibonacci levels is a strong indicator of a reversal.
Trend Lines
One final way that you can go about things is to look at the trend lines that make up your trade. Is the trade sticking within reasonable bounds or does it seem like something is about to break in one direction or the other?
You should ask yourself questions like this simply because you need to be sure that you are viewing things that are truly occurring in the market. If the trends aren’t holding, then the chances that you are looking at a reversal are pretty strong, and it may make sense for you to adapt to this reality and get in on the other side of the trade while you still can.
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