Retracing Trends and Profit Opportunities: Retracement Analysis Is a Simple Way to Study Market Action. There Are No Indicators to Calculate, Plot or Read. There Are No Subjective Price Patterns to Find. There's Just You, a Ruler and a Calculator. Most Important, It Works
Luca, Cornelius, Modern Trader
Currencies are well known for their tendency to form persistent trends, but this doesn't mean they are always trending or existing trends last forever. Assuming your currency pair of choice is in a trend, you should expect a number of pullbacks that might be generated by adversity to short-term sharp moves, profit taking, bargain hunting and a wide variety of other reasons.
The various methods of retracement analysis give you the tools to deal with these inevitable periods when the trend stalls out or even violently reverses.
When it comes to retracements, traders are generally talking about the Fibonacci levels. They are fine and popular tools, but there are more ways to improve your analysis than using the standard group of three horizontal lines. There two other common sets of retracement ratios, designed by Charles Dow and W.D. Gann.
In general, retracement levels are placed at about a third, half and approximately two-thirds of a trend's total length. Analysts typically mark those levels with horizontal lines.
To start the analysis correctly, a trader must measure the length of the price action from the beginning of the uptrend or downtrend to at least the point where it looks like the end of the respective trend is.
"Premature analysis," left, shows the euro advancing since late August. This should be the start of the uptrend. The problem here is while there is a clear beginning, there is no apparent end of the uptrend, so the retracement analysis will have to wait.
However, take a look at the euro/dollar on a different set of dates, during which the pair experienced an entire trend. Retracements can fairly be placed on this chart. "Trend with an end," right, shows an uptrend between August and February, and the two points of the uptrend are linked by a slanted line.
The lines used for retracement react differently compared to the standard support and resistance lines. Support and resistance are supposed to hold; if they break, then the market is expected to fall further, when the support line gives way, or rally when the resistance succumbs to pressure. In the case of retracements, these lines tend to attract price action while maintaining strong support or resistance qualities. Think of them as magnet lines for financial prices, as magnets either attract or repel metal.
In the case of an uptrend, if the first retracement line gives way on a closing basis, then expect the level of that line to become resistance. This means the 50% line will turn into support. Incidentally, this is generally agreed to be the strongest of the retracements, regardless of what set of ratios is used.
If the 50% line breaks as well, then it will turn into resistance, and the next support will become the third line. This is the last line in the sand for the health of the uptrend, and if broken, then the uptrend is officially over. Of course, traders should not wait on losing long positions to see if this last line holds! They should use these lines as possible targets for profit taking on short positions opened after the currency peaked.
The opposite is true for downtrends.
The Fibonacci ratio is named after Leonardo of Pisa, or Pisano, an Italian mathematician, who introduced Hindu-Arabic numerals to Western Europe in his work titled Liber Abaci, or Book of Calculations, about eight centuries ago.
The Fibonacci sequence is a series of ascending numbers in which each factor consists of the sum between the previous number and itself, starting with 0. The beginning of the series looks as follows: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, etc.
The Fibonacci ratio is found in the geometry of the logarithmic spiral, which is a geometric form found commonly in nature. This figure has the property that the ratio of the length of the arc to its diameter is 1. …