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Getting Started With Technical Analysis – Understanding Retracements and Trend Reversal

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As pointed out in the previous article titled Getting Started With Technical Analysis – Support and Resistance, it is important for traders who rely on technical analysis to identify key reversal trends.

The second part of this article will touch on the importance of retracements. Retracements are temporary price reversals that take place within a stronger trend.

Retracements

Some traders and investors also refer to them as correction.

In using technical analysis, it is critical to identify whether the trend is undergoing a retracement or a complete reversal.

There are many theories and methods to identify different types of retracements such as the Gann, Fibonacci, Elliot Wave and more.

One of the basic principles of retracements is that it does not challenge the trend.

Retracements Trend

For example, referring to the illustration above; the second retracement does not challenge the lowest point of the first retracement. The third retracement does not challenge the lowest point of the second retracement. All in all, it is always an upward trend.

The 50 Percent Gann Retracement

There was a man named WD Gann in the early 1900s who noticed the securities that he was trading to have retracements at 50 percent.

For example, if the price is $10 and has moved up to $30, the retracement will normally happen at 50% which will be at $20. You can get this by taking the price movement difference ($30-$10) = $20 and then divide by 50% which is $10. Thus the retracement is by $10 from $30 which is at the $20 level.

This will be a signal to buy because the trend will still be going up.

Gann Retracement

There are also other indicators following the Gann 50 Percent theory. Such examples are Fibonacci Fan and Elliot Wave Principles of which the analysts who came up with these theories were believed to be influenced by Gann’s theory.

Studies have shown that many retracements are not the exact 50% but ranging from 45% to 55%. It still serves as a good guideline to traders today.

Fibonacci Retracements

Another theory about the pattern of retracements is based on a sequence of numbers. The sequence of numbers was developed from an Italian mathematician named Fibonacci. Hence the retracement theory derived from these sequences of numbers is that there will be certain percentage of retracements before a trend reversal.

The Fibonacci retracements will occur at three levels. They are 32%, 50% and 61.8%. Below is a graphic example explaining the pattern.

Once there are retracements of these percentage levels at 38.2%, 50% and 61.8% in a single trend, it is an indicator for a trend reversal.

Elliot Wave Principle

The basic idea behind the Elliot Wave Principle is that price trends have two sections, the impulse wave and a correction wave.

Each impulse wave has five parts: three waves that go in the trend direction and with two that go in the opposite direction.

Impulse Wave

Impulse Wave

Once there is an impulse wave, the trend will reverse to a corrective wave.

Basic Elliot Wave Pattern

The Basic Elliot Wave Principle

This pattern will keep emerging on the price chart throughout the price trend. The Elliot Wave Principle also dictates that whenever the impulse wave hit a new high in a bull market, it is a highly likely indicator for a trend reversal to a bearish market.

Other Indicators in Technical Analysis:

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