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What are Retracements?

ICICIdirect 15 Mins 10 Apr 2023

Imagine you're running a race, and you're doing really well! You're in the lead, and you're feeling great about your chances of winning. But then, suddenly, you start to get a bit tired. Your legs feel heavy, and you're not sure if you can keep up the pace.

So, what do you do? You take a little break, of course! You slow down for a bit to catch your breath and recharge your batteries. This is exactly what we call retracement in stock market. Retracement is a temporary pause or pullback or reversal that happens after a big price increase or decrease. It can give traders a chance to catch their breath and take a look at the bigger picture, before continuing on with their journey. 

Now, imagine that after your break, you start to feel better. You're ready to keep going, and you start picking up speed again. Before you know it, you've passed your competitors and you're back in the lead. This is kind of like what happens in the stock market after a retracement - the price of the stock starts going up again (continuation of trend), and traders who bought in at the lower price can make a profit.

So, retracements are like little pit stops in a race - they give you a chance to catch your breath and get ready for the next leg of the journey. In the world of finance, a retracement is a healthy correction in the price movement of a stock. It gives traders and investors an opportunity to catch their breath and reassess their strategies before the asset resumes its trend.

Retracement is a popular concept in technical analysis that refers to a temporary reversal in the price of an asset within an overall trend. It is based on the idea that after a significant move in the price of an asset, the price often retraces a portion of that move before continuing in the same direction as the original trend. Thus, retracements are a trend in itself but with a direction opposite from the principal/primary trend and with a shorter period and length.

 

The purpose of identifying retracements is to help traders and investors identify potential entry and exit points for their trades. For example, if a stock has been in a strong uptrend, a retracement may provide an opportunity to enter a long position at a lower price. Similarly, if a stock has been in a downtrend, a retracement may provide an opportunity to exit a short position at a higher price.

Several rules have been developed concerning retracements:

  • Retracements are always corrections to the primary trend. For instance, when prices are rising in a strong uptrend, the uptrend is occasionally disrupted by downward corrections or retracements.
  • In an uptrend, the beginning of these corrections is always a resistance point, and the bottom of the retracement is always a support point. 
  • The lower support point is where a new trend line can be plotted from a previous resistance point. 

Thus, a retracement is a smaller trend itself and runs counter to the principal trend. 

The length and time of a retracement can tell us something about the longer trend. A retracement's duration and length can provide information about the larger trend. For instance, you could expect that retracements in a steeply rising uptrend would be brief and wouldn't "retrace" a significant portion of the earlier rise.

  • The general rule is that a strong uptrend requires retracements of only one-third of the previous uptrend. The same is true for downtrends. 
  • If the retracement in an uptrend declines more than 50%, the primary trend is likely to be broken and a warning of a change in trade is possible. 
  • If the retracement is around 68% of the primary uptrend and sustains at that level for 4-5 days, and then the stock moves to the 50% level then a string uptrend is usually about to be generated.
  • However, on the other end, if the price goes below the 68% retracement level then there is a strong chance for a trend reversal and the primary uptrend could change to a primary downtrend soon. 

Thus, the amount of retracement is an indication of the larger trend's strength. A very large percentage retracement may be an indication that the trend is weakening. Retracements provide an entry point at a low enough level, not only for potential future profit, but also close enough to identify a point at which a protective stop can be established to minimum risk. 

Let's take an example of retracement in the stock market. Suppose that a particular stock has been trending upwards and has risen from INR50 to INR70 over a period of time. At this point, some traders who have bought the stock at lower prices may decide to take profits and sell their shares, causing the stock to experience a retracement or pullback in price.

If the stock retraces 38.2% of its previous price increase, it would drop by INR7.64 (38.2% of INR20) to reach a price of INR62.36. This retracement level is calculated using the Fibonacci ratios.

If the stock resumes its upward trend after reaching the retracement level, traders who entered the market at the retracement level would have made a profit. Conversely, if the stock continues to drop below the retracement level, traders who set stop-loss orders below the level would have limited their losses.

In this way, retracements can provide traders with valuable information about potential entry and exit points, as well as risk management opportunities.

Let's say you buy a stock at INR100 per share, and over the next few weeks, the stock rises to INR120 per share. You're feeling pretty good about your investment, but then the stock suddenly drops back down to INR110 per share. This drop is a retracement.

Now, let's say you notice that the retracement level is at 50%, which means the stock could retrace up to 50% of its previous price increase(50% of (120-110)). In this case, the 50% retracement level would be at INR110 per share, which is exactly where the stock dropped to.

If you believe that the stock will resume its upward trend, you could see this retracement as a buying opportunity. You might buy more shares at the 50% retracement level (INR110), hoping to profit when the stock starts to rise again.

This is just one hypothetical example of retracement in the financial markets, and of course, each situation is unique. 

Now, let’s take a real life example. 

Below is the monthly chart of Nifty50 Index. The index was in a primary uptrend from Jan’17 to Dec’19. The first temporary reversal (retracement) to the primary trend begin at the resistance point of INR11,130, and it retraces approx. 38% of the primary uptrend, which bottoms/stops at the support level of INR9,924. As a trader you get to enter at this support level and wait for the next reversal to exit. Now, observe how the index makes a big green candle at the support level and then the uptrend continues till INR11,772. 

At the next resistance level of INR11,772, the index reverses again and retraces 50% of the primary uptrend. Notice that the index again stops at the strong support of INR9,924, which gives the trader an opportunity to accumulate or enter the market at this strong support. The price bounces from this support again and moves upwards closer to the previous resistance of INR12,115. The index retraces 38% of the primary trend and bounces from the support again. 

Finally, after 2 years of a solid primary uptrend, the index breaks its strong support zones of INR11,760 and INR11,142 to move downwards and break into a major downtrend.

At this point, after talking about retracement only for uptrends, its imminent to take an example of retracements in downtrend too.

Below is the weekly chart of Adani Enterprises. The stock was in a primary downtrend from May’15 to Nov’16. The first temporary reversal (retracement) to the primary downtrend begin at the support level of INR39.65. As a trader you get to enter at this support level and wait for the reversal/ retracement to end at the next resistance level. The stock retraces approx. 50% of the primary downtrend, which stops at the resistance level of INR56.8. Observe how the stock shortly makes a big red candle at the resistance level and then the downtrend continues till the next support of INR33.6 

At this support level of INR33.6, the stock reverses again and retraces 50% of the primary downtrend. Notice that the stock again stops at the strong resistance level of INR50, which gives the trader an opportunity to exit the stock after accumulating it at the support of INR33.6. The stock retraces approx. 23.2% of the primary downtrend and reverses from the resistance level of INR50.

Finally, after A 1.5 years of a solid primary downtrend, the Adani stock bounces from its strong support zone of INR33.75 and enters into a primary uptrend till Apr’17.  

Conclusion

In summary, retracement is a widely used concept in technical analysis that refers to a temporary reversal in the price of an asset within an overall trend. It is commonly used to identify potential entry and exit points for trades. However, traders and investors should always consider other factors when making trading decisions and not rely solely on retracement levels.

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