RETRACEMENT LEVELS: AN ART, NOT A SCIENCE

In a recent email, a subscriber asked me to explain the concept of "retracements" and how retracement levels are determined. While I sent that reader a brief personal explanation, I also promised to would devote a full article to that question.

A retracement is a countertrend move. Retracements are based on the thought that prices will reverse or "retrace" a portion of the previous movement before resuming their underlying trend in the original direction. 

There are many different ways of establishing possible retracement levels when it is clear a countertrend move has started. The swing trader can look at previous levels of support or resistance, current moving averages or calculate percentage retracement amounts. All of these tools establish possible targets that may be reached during the countertrend movement. The levels they identify can then serve as a guide to observe the market in real time as it tests these zones.

Percentage retracement thinking comes from three main sources: Dow, Gann and Elliott Wave theory. Each theory proposes amounts that a countertrend movement will retrace. Each school holds that if the countertrend movement is able to overcome one level of percentage retracement resistance, it is likely to test the next higher level. 

Dow Theory thinks of retracements as regaining between 1/3 and 2/3 of the original Primary move. It emphasizes that retracement targets should be thought of broadly. There is no magic number a stock or index market will retrace. The correction to the main trend will be somewhere between 1/3 and 2/3 of the previous move in the Primary direction. The 50% level is specified as an important level to watch in part because it is midway between the 1/3 and 2/3 amounts.

Elliott Wave theory bases its retrenchment targets on numbers in the Fibonnaci sequence first articulated by Leonard of Pisa, a twelfth century Italian mathematician. The Fibonnaci numbers are derived by adding the sum of the previous two numbers. The first several numbers of the sequence are: 1,1,2,3,5,8,13,21,34,55,89,144.

If,  for example, you wanted to find the next number in the sequence you would add 89 + 144 = 233. The ratio of any two sequential numbers in the sequence beginning with 34 is .618. (For example 34/55 = .618.) Elliott in his writing observed that this ratio was the basis of the construction of the Great Pyramid and could be observed in nature, such as in the arrangement of sunflowers. Since human activity was determined by the laws of nature, stock market retracements would often be 0.618 or 0.382 (the reciprocal) of the previous move. Note that the Fibonacci sequence also allows for a 50% retracement, which is one divided by two. 

In his writings William Gann placed great emphasis on the division of prices in thirds and eights. The division into thirds is parallel to Dow Theory. Retracements broken down into eights identifies the following percentage amounts as potentially significant: 12.5, 25, 37.5, 50, 62.5, 67, 75, 87.5 and 100%.

Putting the three theories together, swing traders might look for retracements to achieve the following percentage levels: 12.5, 25, 33.3, 37.5, 38.2, 50, 61.8, 62.5, 66.7, 75, 87.5 and 100%.

My belief is that determining a retracement level is more of a science than an art. In addition to pre-set amounts, the swing trader should examine former support and resistance levels as well as the current position of moving averages. The best approach is to integrate all three tools and establish a zone where a retracement might end. 

As the chart of the Nasdaq Composite below shows, Nasdaq hit a peak of 2055.65 on June 30th and a trough of 1750.82 on August 13th. That move was approximately 305 points. The 33% retracement gave a target of 1850 which the Composite stalled at on August 24th. The next higher level was the 37.5-38.1% retracement which gave a range of 1864-1866. On August 27th, the Composite in fact hit an intraday peak of 1866.25 before retreating. 

The 50% retracement level was at 1903. That plateau was conquered on September 13th when the Composite hit its high thus far in the move of 1919.21. Retracements of 61.8, 62.5 and 66.7% project targets between 1938 and 1953. Note that the Nasdaq breached a solid level of support, which held throughout June and the early part of July, near 1960. The 150- day moving average is currently at 1946 and the 200-day at 1966. This resistance is very likely to stall any further advance in the Composite if the index can indeed make it that far.

Percentage retracements are useful to calculate how far a countertrend movement may be able to carry a stock or index. They are an important part of swing trading strategy since they signal in advance when the market may reverse and resume the direction of the original trend. Although some schools of stock market thought give exact levels at which retracements may stop, my experience says retracements should be treated as a zone and not an exact number. Looked at this way, retracement levels yield targets to be aware of at the same time demanding the swing trader remain alert to the current message of the market.

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