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Reactions and Retracements

(This is the sixth in a series of articles on basic technical analysis originally published in Futures magazine.)

"For every action, there is an equal and opposite reaction" is a scientific principle that, with a little twist, might be applied to trading. Even the strongest price action cannot continue in one direction forever, so, after a market moves up or down, traders expect some kind of reaction. They may call it a "correction" or a "bounce", and it may show up on a price chart as a "flag" or "triangle" or one of the other patterns discussed in earlier articles in this series.

In trading, however, the reaction is often not equal to the initial action, and traders trying to get an edge may spend a great deal of effort trying to calculate just what kind of reactions to expect. They may characterize their action-reaction findings as "waves" or "cycles", but the general intent of their study is to find a way to forecast what the market might do and trade accordingly.

Much of their analysis is based on the concept of support and resistance, which, essentially, is a previous price level that is likely to trigger a future price action. In an uptrend, for example, the market is likely to have a few setbacks along the way. The lows of those setbacks provide "support" for the market -- if traders bought there before, it is likely they will buy there again. It is a basic economic principle: A price that gets low enough will uncover buying and discourage selling; a price that gets "too high" will discourage further buying and may encourage selling. What is "low" and "high" depends on the market psychology at the moment.

Reaction lows and highs show up rather clearly on a chart in hindsight as the chart for the June 2007 Euro Dollar illustrates. After a January high around 91.00 (A), the market reacted back to approximately 90.40. After a rally, the market slipped back to the 90.40 area again in early February (green arrows). On the next test of that support area, buyers gave up, and the market fell through support to a low at 89.50 (B, coinciding with another earlier low, incidentally). Once broken, support often becomes a resistance area on the next attempt to move higher.

Now, another facet of technical analysis comes into play -- retracements. Some traders like to use Gann or Fibonacci analysis to assess the strength of the countertrend and try to forecast how far it will go. That is tied into Elliott Wave analysis, which we'll save for another day. The basic premise of retracements is that traders first look for the market to retrace 38% of the previous move. If a move exceeds that, the next target is 50%; if the move tops 50%, they look for a 62% retracement. Those are the levels indicated by the blue dashed lines on the support-resistance fan on the Euro Dollar chart. Other levels are also used and a market, of course, could retrace 100% of its previous move (the equal reaction) or more.

The most popular retracement level is 50% -- in fact, a whole book on trading a few years ago focused on that technique. Note that the end-of-February 2007 high retraced exactly 50% of the October-to-December (A - B) downtrend on the Euro Dollar chart (a 91.00 high minus an 89.50 low equals 1.50). Divided by 50%, the .75 rally takes the market to 90.25 before the market declines, sputters at the new support area in the 89.50 area in the middle of March and then tumbles further.

A simple pattern shows up on the longer-term move (red support-resistance fan). The move from the high at 91.00 (A) to the low at 87.75 at the end of April (C) was roughly 3.25. As the market rebounded, a trader looking for a 50% retracement would anticipate the market reaching approximately 89.37. Because that is also a zone where support previously occurred, that offers more evidence that this is a potential target. In this case, the market reached the 50% retracement level at the end of May. The market bounced up from the late April low (C) and, now, has the potential to break through to the next 62% retracement level or push back down and seek the lower support levels again.

Despite the allusion to science at the beginning of this article, keep in mind that identifying and using support, resistance and retracements, as with most of the technical analysis we have discussed in previous articles, is an art and not a science. The only thing you can be sure of in markets is that an action will bring a reaction (retracement), and your interpretation may be helpful for setting stops or getting into or out of position.

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