A retracement on a chart means that there is a temporary pullback on the direction of the price action against the longer term trend. A retracement can return to a previous vertical support level like an ascending or descending moving average or a Fibonacci level while a reversal breaks a key previous support or resistance level. While a reversal on a chart means that the current trend has ended and a new trend in the opposite direction has begun a retracement is just a short term swing in price inside a sustained trend before it continues in the original direction.
A retracement isn’t simple to identify in real time as many look like reversals, the key is watching important technical levels and indicators to see if they confirm it is a retracement or warn that it is a reversal. A retracement moves inside an established trend but a reversal breaks the trend in a meaningful way. A retracement is a minor pullback in a trend while a reversal is a major break of the trend.
Trend trading systems should be designed to manage and navigate price action and volatility to capture the profits in a big trend and not be shaken out until their is a confirmed reversal. The purpose of a trailing stop is to keep you in a winning trade until a reversal triggers your exit signal when there is a high probability that a trend is ending. Price targets try to lock in profits near the peak of a trend before there is a reversal in the direction of the price action that will take back open profits.
Retracements of a trend during an open trade can be managed while a reversal should be exited.
In the below example the ETSY chart was in a sustained uptrend over the 50-day exponential moving average until it was finally lost. The pullbacks that remained over the 50-day EMA were retracements before the chart continued higher, the break below the 50-day EMA can be a confirmed reversal of the uptrend as that long term vertical support level was broken. Reversals don’t always turn into downtrends after an uptrend the price can go sideways or attempt to rally. A reversal just attempts to show the current trend is over for now.
