Introduction to Technical Analysis Part 5: Percentage Retracements

Percentage Retracements

It was mentioned earlier that prices do not move in straight lines but with successive peaks and troughs. Prices tend to retrace a certain percentage of the previous move before resuming the previous trend.

The best known is the 50% retracement. In a downtrend for instance, prices may retrace 50%of the previous decline before resuming the move in the original downward direction.This 50% level is a common target for support in an uptrend (or resistance in a downtrend.)

Besides the 50% retracement, there are also minimum and maximum retracement parameters widely recognised by chartists. A minimum retracement is generally one-third and a maximum retracement generally two-thirds of the previous trend.

Even in a strong trend, the prices will tend to retrace at least one third of the previous move, but if the correction exceeds the two-thirds level, then the retracement is more likely to be a trend reversal, (i.e. If the prior trend is to be maintained the correction should stop at the ⅔ point.)

Trading using Percentage Retracements

Percentage Retracements can be used for trading purposes, the goal of the system being to trade in the direction of the main trend, but to take advantage of the reaction retracements to get favourable entry and exit points. In an uptrend, the 33% — 50% area may be considered as a ‘buying zone’ under the market and can be used to enter new (or add to previous) long positions.The same reasoning can apply to downtrends where this 33%-50% zone may be considered as a selling area above the market. Notice here that these zones may well coincide with eactual trend lines discussed earlier in this chapter, thus giving greater strength to these support or resistance levels.

These parameters (33–50–66) are taken from the Dow Theory, while Elliot Wave Theory and Fibonacci Ratios lead to percentage retracements of 38.2% and 61.8%. Some technical analysts combine these two approaches and use a minimum retracement zone of 33% to 38% and a maximum retracement zone of 62% to 66%. Furthermore, users of Gann Theory divide price action into eighths with special importance being given to ⅜ (37.5%), 4/8 (50%) and ⅝ (62.5%).

Widely recognised retracement parameters:

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• Dow Theory: ⅓ and ⅔ retracements, with the price move divided into thirds. (Minimum retracement 33%, Maximum retracement 66%)

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• Gann Theory: Inverse power of 2 (especially ⅜, 4/8 and ⅝)
• Elliott Wave Theory and Fibonacci ratios: (0.618 and 0.382)

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• Schabacker: Only ⅓ or ½ were considered, as anything larger he considered a trend reversal.

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