Retracements are an essential part of the ebb and flow of the stock market. Regardless of the asset type, the price movements always seem to happen in an up & down (zig-zag) manner. The retracements after a move are often used by stock investors & traders alike to create trading positions for their advantage. But how can an investor/trader use retracements for their advantage?
Before that, let’s understand the meaning of retracements.
What is a retracement?
Retracements are small movements in the opposite direction of the underlying trend. If an asset (such as a stock) has been bullish for some time, then a retracement would be a small bearish move after which the bullish nature of the asset resumes.
All boxes highlighted in blue show retracements which are small down-moves within an uptrend.
Retracements are also referred to as pullbacks. Retracements are extremely common in the movement of price and can be seen in any time frame (longer time frame – weekly/daily or smaller time frame – 5 mins/1 min).
How can you take advantage of a retracement?
Retracements are moves in the opposite direction of the underlying trend, therefore they provide amazing opportunities to enter the trend. Now that we know that the price of an asset cannot move in a straight line (to learn more, visit this article – Why stocks don’t move in a straight line?), we can use this to our advantage to obtain a discount while entering a trading/investment position. Since the price cannot move in a straight line, a smart trader/investor always waits for the price to retrace before entering a trading/investment position. Consider a stock which has given a strong up move.
It is unwise for an investor/trader to chase the price & buy the stock which is undergoing a strong up-move. You never know when the up move will end & the retracement for the move will start, so you don’t want to be the one who gets caught at the exact top of the price. A retracement will always come to the rescue for the smart investors & traders which are great opportunities to buy such a stock. Retracements are discounts which can offer a cheaper & more importantly safer area for the traders/investors to buy a stock!
Similarly, it is unwise for an investor/trader to sell at the exact bottom of the price. Just like an uptrend, downtrends also happen with frequent retracement. Such retracements provide a premium price which a smart trader/investor can use to exit (or sell short) the stock. Buying at discount & selling at premium is the easiest way to make money in the market.
When will a retracement occur?
Most new traders/investors try to predict the exact timing of the retracement in a stock. However, just like most things in the stock market, nobody can predict when the retracement will start or end in a stock! To learn more, visit this article – Can anyone predict the stock market? But just because you cannot predict the retracement doesn’t mean that you cannot take advantage of the retracement! Even if the exact time of retracement is not known, it is known the price can (& WILL) retrace sooner or later after a big impulsive move. Once the retracement move is observed, this is where the traders & investors can focus on creating fresh positions.
You can make money in the market without predicting the exact time of retracement in a stock!
But can you predict how much the price will retrace?
Price retracements are not equal in every asset. It is possible for the price to resume its trend after a very small retracement. On the other hand, the price sometimes undergoes a deep retracement before resuming the underlying trend. It is not possible for anybody to predict the exact retracement of the price before it actually happens. However, there is a way to measure & study the retracements with reasonable accuracy.
One of the most commonly used retracement methods in the stock is the Fibonacci Retracements. Fibonacci retracements show us potential locations where the retracement can end & the trend can resume. However, even Fibonacci retracements cannot predict the exact level of retracement for the stock.
Consider the following examples.
The stock has gone three retracements during the uptrend. However, it is quite clear that the three retracements are not equal.
The first retracement was a shallow retracement where the price only reached the 38.2% level
The second retracement was also a shallow retracement where the price reached between the 38.2% & 50% level.
The third retracement was a deep retracement where the price reached under the 78.6% level.
It is quite clear from the example that exact retracement cannot be predicted by any trader/investor. However, understanding how retracement occurs can improve the performance of a trader/investor.
Golden Rules of Retracement
1. No price movement can be a straight move to the upside or downside. Retracement WILL occur which can provide a safe opportunity for traders/investors.
2. Not all retracements are equal. However, you don’t have to take every single trading/investment opportunity. Smart traders/investors can only focus on deep retracements to improve their reward-risk ratio.
3. Never buy/sell a stock when there is a strong impulsive movement. You never know if you are buying at the worst time possible. Always wait for retracements for a better offer.
4. The bigger an impulsive move in a stock, the bigger will be the retracement. Retracements work on percentage values, not absolute values!
5. Retracement occurs even during downtrends. Traders/Investors looking to exit loss-making positions can wait for the retracement (short bullish move during a falling market) to exit their positions at a premium, thereby reducing the losses incurred.
6. Retracements occur on every timeframe and can be used by everyone – positional traders, swing traders, intraday traders, etc.
Conclusion
Understanding retracements is essential for traders/investors to make money in the stock market. Waiting for the retracement promotes patience amongst market participants which is a crucial element for success in the market. However, the final decision of trading or investing depends entirely upon the reader.
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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