Most of us have wondered, at some point, whether a decline in the price of a stock we're holding is long term or a mere market hiccup. Some of us have sold our stock in such a situation, only to see it rise to new highs just days later. This is a frustrating and all too common scenario, but it can be avoided if you know how to identify and trade retracements properly.

Most of us have wondered, at some point, whether a decline in the price of a stock we're holding is long term or a mere market hiccup. Some of us have sold our stock in such a situation, only to see it rise to new highs just days later. This is a frustrating and all too common scenario, but it can be avoided if you know how to identify and trade retracements properly.

What Are Retracements?Retracements are temporary price reversals that take place within a larger trend. The key here is that these price reversals are temporary, and do not indicate a change in the larger trend. 

The Importance of Recognizing RetracementsIt is important to know how to distinguish a retracement from a reversal. There are several key differences between the two that you should take into account when classifying a price movement:

Factor Retracement Reversal Volume Profit taking by retail traders (small block trades) Institutional selling (large block trades) Money Flow Buying interest during decline Very little buying interest Chart Patterns Few, if any, reversal patterns - usually limited to candles Several reversal patterns - usually chart patterns (double top, etc.) Short Interest* No change in short interest Increasing short interest Time Frame Short-term reversal, lasting no longer than one to two weeks Long-term reversal, lasting longer than a couple of weeks Fundamentals No change in fundamentals Change or speculation of change in fundamentals Recent Activity Usually occurs right after large gains Can happen at any time, even during otherwise regular trading