Retrace is a place where price make a pause, retrace a bit, and end up continuing moving on the trend. Reversal is a place where the price just turns and moves on opposite direction. I always having hard time identifying them both. Sometimes I mistaken a retracement for a reversal, and sometimes thinking it was reversal but only it is retracement. How to differentiate them both? After some research I found out few ways to differentiate reversal from retracement. Although they are not completely accurate all the time, they do give me better probability on my trade.
Candle stick pattern.
In my previous post about candle stick here and here, I talk about various pattern. The few common patterns are easily identified as reversal pattern. Some examples are engulfing, morning star, evening star, etc. At retracement, usually there are clutters of “indecisions” candles, such as doji and spinning top; which have very small bodies. But from my experience this is least accurate way to differentiate reversal and retracement. This is because those pattern are shown in retracement too.
Volume
Very little information on this. I learn this from investopedia website. (http://www.investopedia.com/articles/trading/06/Retracements.asp). According to the article, there will be large volume during reversal, and small volume during retracement. This is because retracement is form by profit taking by retail traders.
Trend lines
According to this forum post (http://forums.babypips.com/newbie-island/28589-retracements-reversals.html), trend lines are one simple way to identify reversal. According to the post, trend line is drawn on the tops and bottoms that form a channel. When the price breaks the channel with both new tops and bottom outside it, it could be a reversal.
Chart Patterns
Chart patterns are another way to differentiate reversal and retracement. According to the book “Chart Pattern Trader Supplement”, the patterns can be classified into 3 groups, continuation (retracement), reversal, and both. The most patterns that show continuation are triangles, flags and pennant. The most common reversal pattern is double tops (and double bottoms).
