Retracements are price moves that are opposite to the primary trend. In a bull market, retracements are the short declines that interrupt the long-term trend of rising prices. Bear market retracements are short up moves.
While traders usually think of retracements in terms of price, the concept can also be applied to time. Prices spend most of the time rising in a bull market, and they will retrace advances over shorter periods of time. The reverse is also true, with shorter bounces in a longer bear market decline.
Market moves are usually measured using both price and time. Traders may say that a stock has gone up 15% over the past three weeks. Since prices move both up and down, we would expect the price advance to be partly retraced, and that decline should last for a short period of time in a bull market.
Fibonacci ratios can be applied to either price or time to help define retracements. In either case, the key ratios of 38.2% and 61.8% would be expected to have significance on the chart. Those levels serve as resistance to price advances in a bear market and offer price support on a decline in a bull market.
For example, if prices fell 100 points, traders would look for a retracement to deliver a gain of about 38 points in a subsequent price bounce. From a time perspective, a retracement following a three-week decline should last six to nine days (38.2% of 15 days is 5.73 days and 61.8% is 9.27).
How Traders Use It
When applied to price, Fibonacci retracement levels are expected to forecast support or resistance levels. An example of price retracements is included in the definition of Fibonacci ratios. When applied to the time scale of a chart, Fibonacci retracements are used to forecast the times when a market reversal is likely to occur.
To apply this idea, traders can measure the amount of time a market takes to move from a low to a high. Fibonacci ratios can then be added to the chart from the time when price peaked, and important trend reversals should be expected to occur on days associated with Fibonacci ratios. If a price advance lasted 100 days, price reversals could be expected to last about 38 and 62 days.
The example below shows the bull market move that pushed crude oil to an all-time high in 2008. The price advance lasted 78 weeks. The initial decline unfolded over 30 weeks (38% of 78 weeks). Prices resumed their decline 48 weeks (62% of 78 weeks) after the peak.
Momentum indicators, including the 26-week rate of change (ROC) and Moving Average Convergence/Divergence (MACD), confirmed the price reversals in crude oil. Traders incorporating Fibonacci retracements based on time would have been able to catch the major market turns.
Why It Matters To Traders
Traders have few tools that project precise time targets, which make Fibonacci retracements a useful addition to the trader's toolbox. Knowing that a trend change is expected at a certain time, the trader can watch other indicators, such as momentum, to capture as much of the trend as possible.
(This article originally appeared on ProfitableTrading.com)