A price can move too far and be due for a retracement, also known as a pullback. In all of these cases the price stops moving in its trending direction, and moves in the opposite direction to the trend for a short period of time. This commonly occurs in overbought or oversold conditions or after a trend.
The reason retracements occur is rather simple. Trends occur due to the mass selection of investment positions. The purchase of assets for new positions or closing of short sales, extends an upward price trend. The sale of owned assets or short sale as new positions extends a downward price trend.
People who are entering new positions, at some point they will be forced to close those positions to solidify their paper profits. In an uptrend, asset owners must sell assets to take their profits. Sales create downward pressure, resulting in a retracement downwards. After the sales are completed, upward price movements may resume.
In a downtrend, short sellers must buy assets to take profits and close positions. The buying increases demand and temporarily results in a reversal, creating upwards price movements. After a retracement upwards, which is also known as a dead cat bounce, the price trend often resumes downwards.
While a retracement is occurring, you often will not know if it is a retracement or a reversal in formation. Don’t try to guess where a retracement will end, since you don’t yet know if the trend will continue after the correction or bounce. In many cases, volume will be very light during a retracement or bounce and heavier volume will indicate a full reversal, but reliability is questionable. This is not the only possible signal. You won’t see a bounce or retracement cross important resistance or support levels, and usually stop before violations. If a crossing occurs, the chance the retracement is a reversal increases.
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