The Magic of Retracement Levels

You know that I pay a lot of attention to Reversals of Trend and to Retracements.  Reversals are easy enough to understand and to see on a chart; they occur when prices which have been trending either up or down suddenly stop going in that direction and do a fast turnaround and go in the other direction.  Everything we do at CandleWave is based on estimating likely points of reversal and then scouting them out, even before they emerge.  Most investors are very interested in knowing the point at which a reversal is likely to occur, because it can be safer and more rewarding to get aboard a train just as it is about to leave the station than it is to try to jump aboard when the train is already moving fast down the tracks.

Now, what are “Retracements?”  Simply stated, they are countertrend corrective moves which occur following a Reversal.  It is important to have some idea of the extent to which they may move before they peter out, at which time prices will reverse again, this time in the direction of the operative trend.  That “extent” is expressed as a percentage of the size of the previous move.

Luckily for us, nature has put in place a series of particular percentages which very often prove to be accurate targets for calculating where a corrective move might end.  Four of them come to mind.  They’re easy to remember, with a little practice.  They are the .382 (the “three eighty-two”), the .500 (the “fifty”), the .618 (the “six eighteen”), and the .786 (the “seven eighty-six”).  The first wave down from a major, reversal-generating Top we call “Wave One Down.”  When it reverses and a corrective upmove follows, we call that upmove “Wave Two Up.”

The really interesting thing is that Wave Two Up most often retraces somewhere between 50% and 78.6% of Wave One Down, and usually spends time hovering around the six eighteen before giving up the ghost.

Let me show that to you in real life.  Please look first at the accompanying chart of the Dow Industrials.

At the top of the chart, note that January 19 marked a top at 10729.80.  This was the end of the Great Rally of 2009, which began last March.  “Wave One Down” followed, and bottomed on February 5.  At that point, Wave One Down ended, prices reversed upward, and Wave Two Up was underway.  You can see that Wave Two Up ended on February 19.

I have marked that top end of Wave Two Up by a horizontal green line.

Now, rather than having to measure by hand the percentage extent of Wave Two Up’s retracement of Wave One Down, the computer does it for us.  The computer has measured the price distance between the upper horizontal blue line at January 19 and the lower horizontal blue line at February 5.  The numbers within the small red squares above and below the green line show us that the .618 (being 61.8 per cent, of course) level of retracement was at 10381.22 on the Dow, and that the .786 level of retracement was at 10533.86.  Note that prices reached a High between the .618 and the .786 on February 19 (the green line), and then retreated.  They have pretty much focused on the area between the .5 and the .618 ever since, and closed smack in between the .5 and the .618 on Friday.

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Now please look again at the chart, because there’s more to see.  Now the computer has made a second calculation.  It has measured the price distance between the High on February 19 and the low of last Thursday (February 25), so that we can know the percentage of retracement of the downwave from February 19 through February 25.  Prices zoomed way down early on Thursday before ending up back in the territory between this newly-calculated “fifty” and “six eighteen” again.  Aha! Look where prices closed on Friday! Right between the newly-calculated “fifty” and “six eighteen,” as those numbers are shown in the rectangular red box.

So, the Closing price on Friday is right smack between the “fifty” and the “six eighteen” ON TWO SEPARATE SCALES OF MEASUREMENT – one on the downwave from January 19 and one on the downwave from February 19.  Effectively, prices have been stopped dead in their tracks, so far at least, by the “six eighteen” retracement level, twice in a row.

This knowledge, plus our accumulated knowledge that prices very often are repelled downward from this group of retracement levels, lead us to believe that prices should not top the high of February 19 AND that they should decline from approximately this point, in what is now Wave Three Down.

The accompanying NASDAQ Composite chart shows the same events.  The dates and the numbers are different, but the principle is identical.  The NASDAQ is sitting a little higher, just under the seven eighty-six measured from Thursday’s low.

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William Kurtz

for CandleWave, LLC

February 28, 2010

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