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.

Good trading!

Steven Poser
Editor
The ETF Authority
New York, NY