How to distinguish reversals from corrections
Reversal or correction? That is the question
Everyone wants to ride a new trend from the very beginning. If a trader holds a position in line with the existing trend, he/she wants to close it before this trend reverses. However, at the early stages, it's very difficult to distinguish reversal from a mere correction. The wrong judgment may lead to losses. What are the solutions to this problem?
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A correction or, in other words, pullback or retracement, is a relatively short-term movement of the market in the direction opposite to the main trend. A correction will be bearish in a bullish trend, while in the bearish trend a correction will be bullish.
Corrections emerge as the market gets either overbought or oversold - this can be seen from the readings of oscillators. In addition, there's so called horizontal correction, which is also referred to as sideways market or range. It takes place when demand for a certain asset and its supply balance each other out.
When a correction is over the price returns to the initial trend. Newbies are often advised not to trade counter the main trend as such aggressive trading requires experience and psychological resilience.
Pullbacks are always relative because they are always closely connected with the timeframe. Thus, correction on the weekly chart can be viewed as the main trend on the daily chart. Everything depends on the scale. When the scale changes, various technical analysis patterns may appear.
By extension a reversal differs from corrections by its length within the same timeframe. In other words, while correction is temporary, reversal means that the trend has shifted to the opposite one: uptrend switched to downtrend or vice versa.
When you see that the market is making a countertrend move, the first thing to do is to categorize it. Many traders just don't stop to think whether such move is a correction or a reversal. Yet, posing this question is the first step of a conscious approach to trading.
There are some things which help to tell the difference between correction and reversal:
- Corrections are preceded by a significant market move, a thrust to the upside or the downside, while reversals can occur at any moment.
- Corrections don't depend on fundamental factors, while the reversal is often proceeded by an important news release.
Look at previous highs and lows. If the price goes beyond them, this may signal a reversal.
Perform a visual analysis of the market. When during an uptrend the marker is forming a lower high, this is a significant warning. The first lower low will be a confirmation that the uptrend is over.
Tools to use
There are several techniques which allow measuring the depth of correction: Fibonacci levels, pivot points, trendlines. When price retracement is contained by 38.5% Fibo, the current trend is fairly strong.
If the market goes beyond 50%, this might be a reversal. Support and resistance levels which are provided by pivot points indicators also act as the starting point of a new trend. Trendlines are also very helpful. If the market broke through a trend line, the possibility of a change in trend is substantial.
In all of these cases, the break of a line should be confirmed. The best confirmations usually come from price action: the breakthrough candle should close below the breached level. An ideal situation is when the broken line is retested, but the price fails to return above/below it. Breakthrough confirmation may also come from technical indicators and volumes.
Although the forex market offers traders only a very reduced version of volumes, even tick volume can be of some help. When the trend is not accompanied by increasing volumes and the counter-trend moves are, it's a sign of reversal.
In addition, keep your eyes open for reversal patterns - remember that they make sense only after a trend and don't usually work in the situation of a flat market. Corrections can contain reversal candlesticks, while if there's a reversal chart pattern, then the odds are that you are dealing with a reversal.
Trend indicators may also turn out to be helpful. ADX measures trend's strength, while moving averages act as support and resistance levels. The best MAs to use are 200-, 100-, 50- and 20-period ones - these lines are watched by the majority of traders, making them effective.
Don't rely on only one sign of reversal. Use the technical methods were have offered, but don't forget to check that there are fundamental reasons that really create a new trend. One has to understand that as all methods help, but not guarantee that you'll successfully determine a reversal, it's necessary to use Stop Loss orders: trend lines and retracement levels may be good places for them.