Ratio Retracements

Article excerpt

Forget your high school math? Don't worry -- ratio retracement analysis is a surprisingly easy concept of price and time projection. Read on for a quick course in Fibonacci, Dow and Gann retracement levels, fan lines and arcs.

We often hear the pharse, "What goes up must come down." When commodities aren't advancing or declining in a linear form and trends become subject to the adversity of profit-taking, bargain hunting and innumerable factors, it's only natural to expect pull backs -- even in the hardiest of moves. Traders often flock to the comfort of Fibonacci levels, but ratio retracement analysis offers much more than Fibonacci's three popular horizontal lines.

End of trend A simple, if often ignored, rule is to apply retracements only to trends that appear to have ended. For example, if a commodity has been rallying from 40 for the past month and is closing today near the highest level of its short-term trend at 50, it is premature to apply retracements. However, if it looks like the market already topped out at 50, then you should draw your retracement lines.

Ratios Generally, when talking about retracements, traders religiously assume the reference is to Fibonacci ratios. Leonardo Fibonacci da Pisa's mathematical observations in the 13th century still are providing uncanny results today, as financial and agricultural commodities continue their tendency to retrace, or pull back, about one-third, one-half and two-thirds of a movement. Or, to be exact, 38.2%, 50.0% and 61.8%, where the sum of the first and third ratios equals 100. "Pull back" (below) depicts Fibonacci retracement levels drawn on the Japanese yen futures.

As popular and reliable figures, Fibonacci retracement ratios are not the only ones that work well. You also can use Dow or Gann ratios. While Dow retracement levels closely resemble Fibonacci's with 33%, 50% and 67% ratios, W. D. Gann adds more detail with his emphasis on one-eighth retracements. Gann looked for pull backs toward 12.5%, 25.0%, 37.5%, 50.0%, 62.5%, 75.0% and 87.5%.

Gann ratios' additional levels are valuable in that they alert you sooner and to a finer degree than standard ratios. If the move that is retraced is large, say 240 points, the Fibonacci levels won't register a retracement until a nearly 80-point range has been revisited. But using Gann in the same market scenario will note a 30-point retracement, or one-eighth of the 240-point range.

Fan lines and arcs Horizontal lines are just one of three methods of using ratio analysis. Fan lines and arcs are two other techniques that employ the same ratios used in plotting the horizontal lines. Why should a trader use additional retracements? Not because "the more, the merrier," but because in addition to searching for a price target, you want to determine a time horizon as well.

Benefits Several points about commodity markets can be surmised through the use of retracement analysis and used to your benefit. First, trends retain their composure well if they pull back only around one-third or one-half of a move. In fact, a little pruning reinvigorates trends and often attracts either increased or new money inflows. "Rebuffed rebound" (right) shows how the 33% Dow retracement level in the Swiss franc futures capped rebounds for a good portion of March, but the 50% retracement level held off a two-day attack later that month. However, note that a retracement that moves beyond the two-thirds mark is considered to be a trend failure, as it confirms a change in the original direction.

The second point is that ratios attract a lot of traffic as most traders around The world focus on the same levels. Therefore, it is dangerous to leave entry orders or stop-loss orders at exact retracement levels. For example, if the 38.2% Fibonacci retracement level of an uptrend comes in at 27.00, you can expect to run into profit-taking buy-orders along with fresh entry orders there, while sell-stops likely are to be tucked below 26. …