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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