Retracements: What They Are And The Most Reliable Ones To Use
Prices often
pull back or “retrace” a portion of their previous trend
before resuming that trend. These “retracements” can be measured in
terms of the prior trend. Below we will look at how to calculate commonly
used 38.2%, 50% and 61.8% retracement levels. We’ll also look at ways to
incorporate these levels into your trading.
A Simple Concept
Retracements are a
fairly simple concept. You measure a trend from a significant low to a
significant high and take percentages of that move for likely support and/or
reversal levels. It’s likened to the phrase “two steps forward and one step
back.†If a market did exactly this, then it would be a 50%
retracement.
Commonly Used
Levels
The most commonly
used retracement levels are 38.2%, 50% and 61.8%.
Referring to Figure 1, notice that the retracement levels for the move
from (a) to (b) are
shown on the right side of the chart. Obviously, if the market comes all the way
back to (c) then 100% of the prior move has been
retraced.
Figure
1.
Calculating
Retracement Levels
The first step in calculating a
retracement is to find a starting and ending point for the initial leg to be
measured — the “(a)” and “(b)“
in Figure 1. These should be fairly
obvious. In fact if they are not obvious, you probably shouldn’t be using
retracement levels on this market.
Once the significant low and high is
determined, you then take the percentages of that move to find the retracement
levels. For instance, suppose a stock (or any market for that matter) runs from
50 to 100. You would then take the length of that leg (100-50), multiply it by
the retracement level you wish to calculate and then subtract that figure from
the significant high. So in this case, the 50% retracement would equal the
length of the leg (100-50=50) times 50% = 25. That number is then subtracted
from the significant high (in this case 100). Therefore, the 50% retracement of
the 50 to 100 leg would be 75. The 38.2% would be 80.90 (100 – (50*38.2%)).
The 61.8% retracement would be 69.10 (100 – (50 * 61.8%)).
Let’s walk through an actual example.
Power One
(
PWER |
Quote |
Chart |
News |
PowerRating) rallied from a low of 48 9/16 (a)
to a high of 128 (b). The length of this move is
79.438 points (128 – 48 9/16). 38.2% of this move would equal 30.34 points, 50%
of this move would equal 39.719 points and 61.8% of this move would equal 49.09.
You then take these retracements and subtract them from the high (b)
of 128. This gives you levels of 97.66, 88.28 and 78.90 for the 38.2%, 50% and
61.8% levels respectively. These levels are labeled in Figure 2.
Figure 2.
Retracement levels are available in
most charting packages. As usual, I suggest having the computer do the work for
you.
Why These Levels?
The 50% level is a logical level, as
it half of the original trend. The 38.2% and 61.8% levels are based on Fibonacci
Ratios.
The numerologists believe that the
secret of the universe lies in the Fib numbers. They are quick to point to
relationships throughout nature such as the reproduction rate of rabbits,
planetary relationships and even things such as the level of a woman’s belly-button
in relationship to her body.* I believe that the 38.2 and 61.8 Fib levels simply “caught
on” and quite possibly have become a self-fulfilling prophecy.
Just
a Number or Worth Watching?
In spite of what
some traders/analysts may claim, commonly used retracement levels, in and of
themselves, are just numbers. However, the fact that these levels are
watched by many traders makes them worth watching. This is especially true when
additional technical factors are present.
Combining
Structure
In technical
analysis, the more pieces or “structure” that exists, the better your
chances of success. Therefore, a retracement level that also corresponds with
prior support/resistance or forms some other technical pattern such as a double
top/bottom, is much more powerful than a market that has simply retraced
to a level.
For instance, notice
(Figure 3) that June 2000 Bonds formed a double bottom right at the 61.8%
retracement level (a) of their prior up leg.
Figure
3.
Nextlink
Communications
(
NXLK |
Quote |
Chart |
News |
PowerRating) provides another example in Figure 4. Notice that the
38.2% retracement level (c) of the prior down move
(from (a) to (b)) also
corresponds with recent resistance (d).
Figure
4.
The Best
Retracement Levels
Stocks and
commodities in the strongest trends often only give back 38.2% (or less) of
their prior move. Therefore, as a momentum player, I tend to focus mostly on
this level. After all, once 50% (or more) of the prior trend is given up, one
has to wonder if that prior trend is still valid. I will consider levels deeper
than the 38.2% but only if there is some additional pattern or
“structure” in place.
As you know, in
trading there are no “exacts.” Some believe that deeper corrections
provide a safer entry as it likely that more sellers (or buyers for downtrends)
have already been shaken out of the market.
Therefore,
considering the above, the best retracement levels depends on your own personal
trading style.
*Due
to the fact that I am married, I’m not allowed to conduct surveys on navel levels
of women. Therefore, I have to take their word for it.
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