ETF Authority Educational Archive -- RETRACEMENTS
Markets do not trade in just one
direction. They zig up and zag down. They often trade in ranges for long
periods of time, then explode higher or lower. Technical analysts look
for likely resting points to act as support or resistance when trends
pause and consolidate. These areas of likely support or resistance
usually congregate around certain percentage retracements between
historical highs and lows.
A QUICK EXAMPLE
To give you a better feel for exactly what I mean, here's a quick
example. Let's say shares of fictional trading company XYZ Inc. have
just risen from $100 to $200 per share on news that its founder just was
named "Technician of the Century." Unfortunately, the stock
closed the day at $195 and has signaled a correction due to a bearish
engulfing pattern on the Candlestick chart. One possible retracement
would be 25% of the gains from $100. You can compute this by first
determining what that 25% figure would represent in dollar terms:
0.25*($200-$100) = $25. Next, subtract $25 from $200 to give a
retracement target of $175.
HOW DO I KNOW WHAT PRICES TO USE FOR THE
RETRACEMENT CALCULATION?
I could write a book about this. In fact, I did! My method for
determining where and when you should be looking for retracements is the
Elliott Wave Theory. I cannot go into a detailed explanation of Elliott
here (if you're unfamiliar with this type of analysis, then you'll want
to refer to Lesson #5 (available only to paid subscribers and
limited-time FREE trial members -- click
here to learn more) in my ETF trading course, which focuses on
Elliott Wave Theory, before continuing any further). However, in short,
you should look for retracements following completed three-wave and
five-wave Elliott patterns. (If you aren't familiar with Elliott Wave,
then don't worry -- I'll take care of that analysis for you in this
newsletter. However, if you'd like to learn more about Elliott Wave,
then you may want to review my newest book -- Applying
Elliott Wave Theory Profitably.)
In addition to Elliott patterns, many traders and investors will look at
non-Elliott moves and will compute retracement levels off of these price
actions. While I would be less inclined to expect those levels to be
important outside of an Elliott Wave framework, if many people are
looking at a similar price move, then those retracement levels may very
well hold.
DO YOU FAVOR ANY PARTICULAR RETRACEMENT
PERCENTAGES?
My hidden agenda comes in right here and now! In addition to the 50%
retracement level, which occurs halfway between the high and low of a
given move, the retracements that I find most reliable are those related
to so-called Fibonacci ratios. Other commonly-followed retracement
ratios include 1/4, 1/2, and 3/4.
As many of you know, Leonardo of Pisa, who went by the name Fibonacci,
was one of the great mathematicians of his time. He lived around 1175
AD. Fibonacci developed a number series (he did not name the series
after himself -- that came hundreds of years later) that answered the
following problem: A pair of rabbits are put in a field and, if
rabbits take a month to become mature and then produce a new pair every
month after that, how many pairs will there be in twelve months time?
The series is computed by summing the two prior numbers in the series to
get the next. If we start at 0 and 1, the next number is 1 (0+1)
followed by 2, 3, 5, 8, 13, 21, 34 and so on to infinity. As you
approach infinity, the ratio of the nth number divided by the next
number in the series approaches 0.618, or 61.8%. If you divide number n
by number n+2, you get 0.382. Meanwhile, n divided by n+3 begets 0.236.
I also look at 0.764, which is merely 1-0.236, for retracement levels.
Many people use the square root of 0.618, which is 0.786. That is very
close to 0.764, so feel free to use one or the other.
The number 0.618 is also known as the "Golden Ratio," or phi
(a Greek letter). It is supposed to have special properties. The
pyramids and many items in nature apparently have properties related to
this ratio. However, that is beyond the scope of this article.
WHAT ARE TYPICAL
RETRACEMENT PERCENTAGES?
That depends on what kind of wave you are retracing (in Elliott Wave
terms). Typically, wave-1 is retraced by at least 38.2% and rarely by
more than 61.8%. 50% is very common (50% is not a Fibonacci ratio). A
third wave is often retraced by only 23.6%, and in general should not be
retraced by more than 38.2%. Never say never, though, as I have seen
61.8% retracements of some third waves.
Retracements within corrections are much more difficult to determine. An
A-wave may be retraced by 76.4% and usually is retraced by at least 50%,
unless the reversal is very powerful. If wave-A subdivides into three
waves, then it should be retraced by at least 61.8% (and could retrace
by 100% or more).
SUMMARY
Most technical analysis charting packages provide a Fibonacci
retracement tool. Use it on key highs and lows and you will see how
often prices turn at or near Fibonacci or 50% retracement levels. I
cannot overemphasize the importance of NOT using a never-ending stream
of possible retracement levels. After all, the law of large numbers says
that sooner or later, one of these levels will be hit. Instead, you
should focus on just a few. I use 23.6%, 38.2%, 50.0%, 61.8% and 76.4%.
You can easily replace 23.6% with 25.0% and 76.4% with 75% or 78.6%. For
all but the very largest moves, the calculated price levels will be
nearly identical. When trading, you should try to set your stop-loss
levels around these prices. Therefore, daytraders should always be very
cognizant of exactly where these retracements sit.
The key to using retracements is to see how prices act at and around
these levels. If the level does not hold, then the trend may accelerate.
If it does hold, then you should examine the trading action after that
to see if the price level appears to be a major reversal or a temporary
one. This is where an Elliott Wave framework can help you immensely.
Good trading!
Steven Poser
Editor
The ETF
Authority
New York, NY
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