What it means
Markets rarely move in a straight line. Even in a strong rise, prices tend to dip back before pushing higher, and in a long fall they bounce before dropping again.
These interruptions are retracements, and they are a normal part of how trends develop. The difficulty is telling a retracement from a reversal.
A retracement is expected to end, after which the original trend continues, whereas a reversal means the trend has ended and a new one has started. Traders look at the depth of the move, the trading volume and other signals to decide which one they are seeing.
A common way to measure retracements is to use Fibonacci levels. Traders take the size of the previous move and mark typical pullback depths of 38.2%, 50% and 61.8% of it.
These levels are not laws of nature, but many traders watch them, which can make them influential in practice. Retracements matter to non-traders too.
A company's share price may drop 8% after a strong run, and the finance team must decide whether to treat it as noise or a warning. Portfolio managers use retracements to time purchases, aiming to buy during a dip in an uptrend.
Volume gives useful context. A pullback on light trading often signals a pause, while a drop on heavy trading suggests that many holders want out and the trend may be in trouble.
The main risk is assuming that every dip will be followed by a recovery. If the price falls through the expected levels with heavy trading, the pullback may turn out to be the start of a reversal.
Using stop-loss orders (instructions to sell automatically at a set price) helps limit the damage if the judgement is wrong.
In practice
Real-world examples.
Example
An investor watches a technology share climb from $80 to $120 and then fall back to $104. She calculates that the dip is 40% of the previous rise, so she treats it as a normal retracement and adds to her holding.
Example
A currency trader sees the euro fall against the dollar by 600 pips and then bounce 250 pips. He labels the bounce a retracement within a downtrend and waits for the price to stall near the 50% level before selling. If the bounce goes past that point on strong volume, he will cancel the idea and stay out.
Example
A company treasurer watches the price of fuel, a major cost, after a sharp rise. When prices dip by a third of the increase, she buys part of next year's requirement under a fixed-price contract, expecting the rise to resume.
Formula
Calculation
Retracement level = High point - (High point - Low point) x Retracement percentage
Suppose a share rises from a low of $100 to a high of $150, a move of $50. A 38.2% retracement is $150 - ($50 x 0.382) = $150 - $19.10 = $130.90. A 50% retracement is $150 - ($50 x 0.50) = $125.00. A 61.8% retracement is $150 - ($50 x 0.618) = $150 - $30.90 = $119.10.Case study
Seen in the real world.
Brackenridge Capital is an illustrative, fictional trading desk that bought shares in a shipping company after a strong rise. Two weeks later the price fell by 8%, and the junior trader panicked and wanted to sell.
The senior trader reminded him that the prior rise had been 40%, so an 8% dip was well under half of that move in price terms. The fall was on light volume and the price stopped above the 38.2% level, so the desk held the position.
In this fictional case the price recovered and reached a new high within a month. The illustrative lesson is that measuring a pullback against the earlier move helps decide whether it is a normal pause or a warning, although the desk also kept a stop-loss in place in case the analysis was wrong. The junior trader later wrote the retracement levels on a card beside his screen.
Watch out
Common mistakes.
- Treating every price fall as a retracement when some are genuine reversals.
- Believing that Fibonacci levels are guaranteed to hold, when they are only reference points that many traders watch.
- Buying a dip without any stop-loss or plan for what to do if the price keeps falling.
Questions
People also ask.
What is the difference between a retracement and a reversal?
A retracement is a temporary move against the trend after which the trend resumes, while a reversal is a lasting change of direction.
Which retracement levels do traders watch most?
The most popular are 38.2%, 50% and 61.8% of the prior move, and many traders also watch the 23.6% and 78.6% levels, though none of them is a guaranteed turning point.
Does a retracement apply to falling markets?
Yes, in a downtrend a retracement is a temporary rise, and traders use the same percentage levels to judge where it might stall.
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