The pullbacks in a trend (retracement) will help you measure the strength of the prevailing trend. It is not enough to simply track a stocks price but a trader must have a way to understand the strength (or weakness) of a trend.
Retracements are best thought of as the percentage move counter to the prior trending move. So if a stock advances 4 dollars in price and then pulls back 2 dollars then it has had a 50% retracement.
Retracements in a stock are important to measure as they constantly confirm or put into question the prevailing trend. When a stock pulls back up to 40% of its prior move and then advances to a new high this is actually very healthy as you might think.
Here are the levels you can use:
- up to 40%
What is nice about retracement levels is you can visualize them right on the chart. They are not specific exact points but should be thought of as areas. As a stock is going through its trading day for intra day traders or daily gyrations for longer term traders the amount it pulls back before its next advance is your clue to its strength.
Any retracement of a stocks prior advance up to 40% is bullish. A retracement that drops to 50% or near half of the prior advance can still be bullish but place a small question mark by it and think of it as neutral. Since no one is making anyone else trade it just pass on it for a better probability. A stock that retraces 60% or more of its prior move is putting that trend in serious question. A strong stock should not fall back that much if it is going to go on to new highs.
The 100% retracement was mentioned because it has some special attributes. As you can imagine a stock that falls back to erase its entire prior move is not bullish in anyway it is a point where a stock will often bounce back up due to the support at that area. There are many traders who trade support areas like this as a set up in their trading plans but their target area to sell has very reduced expectations.
Here is where the strength meter comes in. You have probably guessed that the more a stock retraces its prior move the higher its probability is to reverse its trend.
Most trading platforms will have a tool that you can readily draw in retracement levels and having those lines in place while you watch a stock you are interested in trade is very instructive. However you can easily watch this visually.
We are getting close to having all the details of our buy set up in place. We will cover support and resistance next and then we can put it all together.
Trade with a plan.
Don’t have a plan? Hope and luck are not trading plans.
These articles feature excerpts from Create Your Trading Plan