A retracement is a price move in a commodity, stock or index. To be specific, it is a move counter to a previous trend. For example, if the Dow ($INDU) rallies from a low of 12,000 to 12,500, it has added 500 points. If the Dow then falls 100 points, it has retraced a percentage of those gains. Market technicians often look at specific percentage retracements in order to find areas of support or resistance. The latest action in the Dow Jones Industrial Average provides a good working example.
Before looking at the Dow, however, let's talk a little bit more about the logic underlying retracement levels. While there are many different ways of using this type of technical analysis, most studies are based on the work of Italian Mathematician Leanardo Fibonacci. According to some historians, Fibonacci observed numerical relationships after studying the Great Pyramid of Gizeh in Egypt. Specifically, he recognized that each successive number is the sum of the previous two:
Other relationships exist between the numbers as well. For example, each successive number is equal to 1.618 of the prior number. Also, any number is equal to .618 of the following number. Much like Fibonacci numbers, some technical analysts believe that there is a certain order or logic that can help make sense of price moves in a commodity, stock or market. In order to capitalize on that information, traders have developed a variety of visual tools including fans, arcs, and time zones.
Retracement levels are often drawn using lines. Figure 1 shows the retracement lines on the Dow Jones Industrial Average over the past year (through Monday). The most recent advance carried the average up from roughly 10,750 to 12,750, or 2000 points. However, since mid February, the Dow has come under pressure. It fell through a 23.6% retracement during a brutal sell off last week. It dipped towards the 38.2% retracement on Monday.
Figure 1: Dow Jones Industrial Average and Key Retracement levels
(click here for larger view)
As each of the retracement levels gives way, it calls into question the legitimacy of the previous advance. Key retracement levels include 23.6%, 38.2%, 61.8%, and 78.6%. (Some traders also use 50%, but 50% is not really a Fibonacci ratio.) If the Dow falls below 11,500 and the 61.8% retracement, most technicians will agree that the previous bullish trend has been negated.
Importantly, however, most traders do not look at Fibonacci levels in isolation, but also consider other indicators as well. For example, at the 38.2% level, which coincides with 12,000, the Dow has found support in the past (notice the arrow in November 2006). Therefore, if that level gives way, a significant support level has been broken. This would spell bad news for the Dow. Moving averages, trendlines, and other indicators are often used along with retracement levels.
So far, the industrial average has rebounded and only dipped below the 23.6% retracement. Figure 2 shows the action on Tuesday, which included a 158-point rally. Now, the technician might also look at retracement levels as the Dow climbs higher. For example, on Tuesday, the Dow rose towards 12,200, which coincides with the 23.6% retracement. A move above 12,340 would push the average above the 38.2% retracement. A move beyond the 61.8% retracement, or roughly 12,500, and the recent decline has been negated.
Figure 2: Dow Jones Industrial Average and Retracement Levels
(click here for larger view)
Fibonacci retracement levels can be applied to any stock, index or market. For example, many players in the foreign exchange market use Fibonacci levels. As a result, it is not unusual to see a currency pair to move towards and then turn away from a key Fibonacci level. Indeed, it can be uncanny at times and, given the advances in charting software, it is also relatively easy to include this type of analysis in day-to-day trading.
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