The concept of retracements is an important key to predicting where price movements are likely to end. Retracements can also serve as low risk entry points when combined with buy or sell patterns and support or resistance.
Retracements allow traders to know where a turn in price might occur. They also serve as a way to know how strong the preceding trend was and just how strong the next move is likely to be.
In the following Wiki on Retracements, we will explore all the various retracement levels, the M and W Formations and the most commonly used retracements amongst financial market traders.
This Wiki is part of the larger Price Action Analysis Wiki. You can access the Price Action Analysis Wiki HERE.
This Wiki is also a part of our Essential Forex Trading Guide. Be sure to check that out HERE.
Retracements
The concept of retracements is an important key to predicting where price movements are likely to end. Retracements can also serve as low risk entry points when combined with buy or sell patterns and support or resistance.
Retracements allow traders to know where a turn in price might occur. They also serve as a way to know how strong the preceding trend was and just how strong the next move is likely to be.
Retracements keep the traders’ expectations in check. They can prevent the trader from projecting their hopes or fears into their expectations of the next move by keeping them objective about how far a move is likely to go. Never expect too much from the market.
A bullish retracement is a downward price move in the exact opposite direction of the most recent up move. For example, if a stock moves up $4.00 and then retraces $2.00 it has experienced a 50% retracement. If that same stock retraced the entire $4.00 then it would have experienced a 100% retracement and could possibly set up a double bottom buying opportunity.
A bearish retracement is an upward movement in the opposite direction of the most recent down move. For example, if a stock declines $4.00 then rallies back $2.00 it has experienced a 50% retracement. If that same stock had rallied back the full $4.00 then it would have experienced a 100% retracement and may have the potential to set up a double top shorting opportunity.
Retracement Analysis
Retracement analysis is used to objectively measure the strength or weakness of a move counter to the prevailing trend.
The level of retracement between the most recent pivot points or congestion areas will suggest the odds of continuation or failure of the prior move. The level of retracement into a reference point of supply or demand will suggest the odds of moving through it. This can give traders clues and insights into what is occurring in longer timeframes. The deeper the retracement, the more bullish or bearish the pattern is becoming in the longer timeframe.
The angle of retracement shows us how the stock or market has recovered through time. Sharper angles of retracement with clean price patterns offer higher probability reversal patterns when trying to get back on a trend in a pullback. However, self-correcting trends with multiple areas of congestion or supply and demand make it harder for prices to move smoothly through these areas and offer lower odds for price patterns to work out as expected.
100% and greater than 100% retracements that begin from a V top or bottom will have greater odds of continuation in the direction of the retracement.
Every deep retracement will create a void of supply or demand that should be considered before placing a trade. If there is a steeper than normal retracement in an uptrend or downtrend, you can use the 40-60% retracement concept as a profit target or to adjust stop losses.
40% Retracement Level
After a 40% retracement of the prior move, the trend is considered to be positive and has good odds of continuation. The trend should continue in the preceding direction. The demand or supply is strong enough to carry the market in the direction of the preceding trend (see figure 7.1).
Figure 7.1: 40% Retracement levels for Up and Downtrends.
50% Retracement Level
After a 50% retracement of the prior move, the trend is considered positive to neutral and still has good odds of trend continuation. The demand or supply is still strong and should continue in the preceding direction. This is the retracement level that many traders focus on. They will tend to exit all or part of their positions in the area of the prior high or low (see figure 7.2).
Figure 7.2: 50% Retracement levels for Up and Downtrends.
60% Retracement Level
After a 60% retracement of the prior move, the trend is considered neutral to negative. The Prior advance or decline is now in question and traders need to be aware of changing market conditions (see figure 7.3).
Retracements of 60% or more in a shorter timeframe are becoming a reversal candlestick in a longer timeframe. This is very important to consider when evaluating the trend's ability to continue in the prior direction. This also highlights the need for multiple timeframe analysis.
The one thing that can make a 60% retracement desirable is the larger price target to the prior high or low but achieving that target will not be as frequent as it would be from a 40-50% retracement.
Figure 7.3: 60% Retracement levels for Up and Downtrends.
80-100% Retracement Levels
After an 80-100% retracement, the trend is considered negative and doubtful of the trend continuing (see figure 7.4).
Tradable retracements can occur from major support or resistance areas but the quality of these retracements will depend on the way that prices declined or advanced. It must be a clean decline or advance retracement that creates a price void in order for a buy or sell pattern to have better odds of being successful.
Figure 7.4: 80-100% Retracement levels for Up and Downtrends.
100% or Greater Retracement Levels
A retracement greater than 100% will have taken out the prior major support (demand) or resistance (supply). This totally negates the prior move and is likely to set up a trend reversal on the next move in the direction of the preceding trend if it fails to follow through. This exhaustion of supply or demand often sets up a high probability reversal (see figure 7.5).
Continuation of a move, after a greater than 100% reversal, is greater when the price move begins from a base, double top or double bottom.
Figure 7.5: Greater than 100% Retracement levels for Up and Downtrends.
M Formations
M formations set up the unexpected when traders have expectations of trend continuation. It is a failed pattern, a failure to take out the prior high (see figure 7.6). Traders holding onto long positions during the preceding strong uptrend expect a continuation of that up move. The shallow retracement against the uptrend suggests strength for the move which brings in additional traders who missed the initial rally. The failure to overcome the overhead supply at the prior high can quickly change the expectations of these traders causing a sharp selloff.
Increased volume at the highs of the M pattern makes this pattern more potent and significant as this signifies that many traders committed to the uptrend near the dead highs and this can create a strong reversal if they all exit the position at the same time. These are the types of double tops that traders really want to focus their trading on.
Most M patterns begin from a less than 40% pullback against the original uptrend move. The stock or market didn't have enough of a chance to blow off some steam and recharge before the new rally began prematurely. There were still many traders that wanted to take a profit near the prior high or got into the trade late.
The M formation is usually not a tradable pattern until the right side of the M has formed a reversal candlestick and the low of that reversal candlestick has been violated by price. Stops should be placed somewhere above the reversal candlestick on the right side. The M formation is a confirmed pattern once the prior neckline low (middle of the M) is broken by price.
Combining an M formation with an unfilled gap is a very powerful combination in the stock market.
Figure 7.6: The M Pattern.
W Formations
W formations set up the unexpected when traders have expectations of trend continuation. It is a failed pattern, a failure to take out the prior low (see figure 7.7). Traders holding short positions during the preceding strong downtrend expect a continuation of the down move. The shallow retracement against the downtrend suggests strength for the decline which brings in additional traders who missed the initial decline. The failure to overcome the demand at the prior low can quickly change the expectations of these traders.
Increased volume at the lows of the W pattern makes this pattern more potent as this signifies that many traders committed to the downtrend at the very lows and if they all panic together it can create a very sharp reversal. These are the types of double bottoms traders want to focus their trading.
Most W patterns begin from a less than 40% pullback against the original downtrend move. The stock or market didn't have enough of a chance to blow off steam and recharge before the new decline began prematurely. There were still many traders that wanted to take a profit in the area of the low or got in too late near the prior low.
The W formation is usually not a tradable pattern until the right side of the W has formed a reversal candlestick and the high of that reversal candlestick has been violated by price. Stops should be placed somewhere below the reversal bar on the right side. The W formation is a confirmed pattern once the prior neckline high has been broken by price.
Combining a W formation with an unfilled gap is a very powerful combination in the stock market.
Figure 7.7: The W Pattern.
40-60% Retracement
There are many different retracement levels that have gained popularity over the years. The 50% by far is the most relevant of them all. Because it is too dangerous to demand or require the market to be too precise, the focus should be on an area or zone that covers 40-60% retracement area, rather than the exact 50% spot.
Any rebound or decline from the 40-60% retracement range should be considered more potent than from other percent retracement levels. Combining the 40-60% retracement level with minor support or resistance will make the probability of a trade producing profit much greater.
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