Retracements

What Is Retracements?

Retracements refer to temporary pullbacks or reversals in the prevailing direction of a security's price. These are considered pauses within a larger, ongoing trend lines rather than a complete change in direction. They are a core concept within Technical Analysis, which involves studying historical price action and volume to forecast future price movements. Traders and investors use retracements to identify potential entry or exit points, assuming that the original trend will eventually resume after the temporary counter-move.

History and Origin

The concept of identifying price pullbacks within larger trends has been integral to technical analysis since its early days. While no single "inventor" of retracements exists, the underlying principles are deeply rooted in classical charting theories, which suggest that markets move in waves and patterns, not in straight lines. The development of modern technical analysis, often attributed to figures like Charles Dow, emphasized the importance of primary trends and secondary reactions (retracements). A significant development for retracement analysis came with the application of the Fibonacci sequence to financial markets. The Fibonacci sequence, a series of numbers where each number is the sum of the two preceding ones (e.g., 0, 1, 1, 2, 3, 5, 8, 13...), was introduced to Western European mathematics by Leonardo Pisano, known as Fibonacci, in his 1202 book Liber Abaci.⁶ The ratios derived from this sequence, such as 23.6%, 38.2%, 50%, 61.8%, and 78.6%, later became widely adopted in financial charting to pinpoint potential retracement levels.

Key Takeaways

Retracements are temporary price pullbacks within a larger, dominant trend.
They differ from full reversals, as the expectation is that the original trend will continue.
Traders use retracement levels, often based on Fibonacci ratios, to identify potential areas of support levels or resistance levels.
Understanding retracements can aid in timing market entries, exits, and managing risk management strategies.
The effectiveness of retracement analysis relies on the premise that market psychology and price patterns tend to repeat.

Formula and Calculation

While there isn't a single "formula" for retracements themselves, the most common application involves calculating Fibonacci retracement levels. These levels are derived by taking a significant price move (either an uptrend or a downtrend) and drawing horizontal lines at specific percentages of that move. The key percentages are 23.6%, 38.2%, 50%, 61.8%, and 78.6%.

To calculate Fibonacci retracement levels for an uptrend:
Let (H) be the high price of the trend and (L) be the low price of the trend.
The total move is (M = H - L).

Retracement levels during a pullback from (H):

23.6% Retracement: (H - (0.236 \times M))
38.2% Retracement: (H - (0.382 \times M))
50% Retracement: (H - (0.500 \times M))
61.8% Retracement: (H - (0.618 \times M))
78.6% Retracement: (H - (0.786 \times M))

For a downtrend, where the price is rallying from a low point:
Let (H) be the high price of the trend and (L) be the low price of the trend.
The total move is (M = H - L).

Retracement levels during a rally from (L):

23.6% Retracement: (L + (0.236 \times M))
38.2% Retracement: (L + (0.382 \times M))
50% Retracement: (L + (0.500 \times M))
61.8% Retracement: (L + (0.618 \times M))
78.6% Retracement: (L + (0.786 \times M))

These levels are not fixed rules but rather potential areas where price action might pause or reverse before continuing the dominant trend.

Interpreting the Retracements

When observing retracements, traders typically look for price to find support or resistance at the calculated percentage levels. For example, in an bull market, if a stock pulls back after a strong advance, analysts might watch the 38.2% or 50% retracement levels as potential areas where buyers could step in, causing the price to resume its upward trajectory. Conversely, in a bear market, a temporary rally might encounter resistance at these same levels, indicating that sellers could regain control. The significance of a retracement level is often enhanced if it aligns with other chart patterns or historical support and resistance zones.

Hypothetical Example

Imagine a stock that has been in a strong uptrend, moving from a low of $50 to a high of $100. This represents a $50 move.
After reaching $100, the stock begins to pull back. A trader might calculate the potential retracement levels:

Total move: $100 - $50 = $50
38.2% Retracement: $100 - (0.382 * $50) = $100 - $19.10 = $80.90
50% Retracement: $100 - (0.500 * $50) = $100 - $25.00 = $75.00
61.8% Retracement: $100 - (0.618 * $50) = $100 - $30.90 = $69.10

If the stock then dips to around $75.00 before reversing and continuing its climb past $100, this would be an example of a 50% retracement holding as a support levels, aligning with the expectation that the primary trend would continue.

Practical Applications

Retracements are widely used by traders for various purposes:

Entry Points: Traders may wait for a pullback to a key retracement level before entering a trade in the direction of the dominant trend, aiming for a more favorable entry price.
Target Setting: Conversely, if a trend is retracing, traders might project where the subsequent move in the original direction could end, often using Fibonacci retracement extensions.
Stop-Loss Placement: Retracement levels can help in setting appropriate stop-loss orders, placing them just beyond a significant retracement level where a break might indicate a trend reversal rather than a mere pullback.
Confirmation: When a stock exhibits a "golden cross" – where the 50-day moving average crosses above the 200-day moving average – this is considered a bullish signal in technical indicators and can be followed by minor retracements that present further buying opportunities before the trend continues. For example, the S&P 500 recently experienced a "golden cross" in early 2023. Thi⁵s kind of event can often be followed by minor retracements that traders watch for continued bullish momentum.

Limitations and Criticisms

Despite their widespread use, retracements and technical analysis in general face criticisms. One primary concern is the subjective nature of identifying significant highs and lows from which to calculate retracement levels, which can vary among analysts. Additionally, some critics argue that technical analysis can become a self-fulfilling prophecy: if enough traders believe a certain retracement level will hold, their collective actions may make it so, rather than the level being inherently predictive.

Furthermore, the Efficient Market Hypothesis (EMH) posits that all available information is already reflected in asset prices, making it impossible to consistently achieve abnormal returns by analyzing past price patterns. Fro³, ⁴m this perspective, prices follow a "random walk," and historical data offers no reliable prediction of future movements. Whi²le some academic research has questioned the usefulness of technical analysis for consistent profitability, proponents often argue that it remains a valuable tool for understanding market sentiment and managing trades, especially when combined with other forms of analysis.

##¹ Retracements vs. Reversals
The distinction between retracements and reversals is crucial in technical analysis. A retracement is a temporary counter-trend move that is expected to eventually give way to a continuation of the original dominant trend. It's seen as a healthy correction or pause. Conversely, a reversal signifies a complete change in the prevailing trend. What was an uptrend becomes a downtrend, or vice versa. The challenge for traders lies in discerning whether a price movement is merely a retracement or the beginning of a full reversal. This often involves looking for signs such as increased volatility, higher volume on the counter-trend move, and the breaking of key support levels or resistance levels that indicate a shift in underlying market dynamics rather than a temporary pause.

FAQs

Q: Are retracement levels guaranteed to hold?
A: No. Retracement levels are not guaranteed to hold. They are potential areas of interest where price action might pause or reverse, but market conditions can always lead to prices moving through these levels. They serve as probabilities, not certainties.

Q: How do retracements relate to market cycles?
A: Retracements are a natural part of market cycles. Prices rarely move in a straight line; they advance and retreat within larger trends. These pullbacks are the retracements, occurring during both expansion and contraction phases of a cycle.

Q: Can retracements be used for short-term trading?
A: Yes, retracements are commonly used in short-term trading strategies to identify optimal entry points for trades aligning with the prevailing trend. For instance, a day trader might wait for a stock to retrace to a Fibonacci level before entering a long position in an intraday uptrend.

Q: What is the significance of the 50% retracement level?
A: The 50% retracement level is widely considered significant, even though it is not a direct Fibonacci ratio. It is often viewed as a psychological midpoint of a price move. If a price retraces 50% and then resumes its original direction, it can signal strong conviction in the underlying trend.

Q: Are there other types of retracement tools besides Fibonacci?
A: While Fibonacci retracement is the most popular, other tools such as Gann fans and traditional pivot points can also be used to identify potential retracement areas based on different mathematical or geometric principles.