We talked about trends, support and resistance. Today we'll discuss retracement. As you know, nothing goes up for ever. At some point the market reverses and starts to go down. Things are just too expensive and people start taking profits. When you see a reversal in a trend, it is important to know how far it may go before hitting bottom and starting back up.
The amount that the market falls before reversing again is called retracement. The first retracement level is 33%. Another nearby retracement level is 38.2% (the inverse of the ratio of one Fibonacci number to the next or 61.8%). The most common retracement is 50%. An extreme retracement is the Fibonacci ratio of 61.8% from the Elliott Wave Theory.
So how do you use this? You start looking for a support level after a retracement of 33%. You check ADX (Average Directional Index) to see if it is signaling a weakening trend (dropping below 40) or entering range trading (dropping below 20). If not, look for the next retracement level and repeat the exercise.
When you find confirming indicators, it is a signal that a support level may have been reached and that an opportunity to purchase may be near.
Happy trading to you until we meet again (with apologies to Roy Rogers.)
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