Retracements are a key charting tool used by futures traders to predict price movements and select entry points. The key value in retracements is that they keep the successful futures trader grounded in reality. They provide traders with an objective view of actual market movement. They help futures traders keep their hopes and fears in check and deal with market movement dispassionately.
Every schoolboy is familiar with the physics concept: “for every action there is an equal and opposite reaction.” For unknown reasons, financial markets appear to follow the same basic laws that affect our physical world. Therefore, in the market any price move up or down must be followed by a similar move in the opposite direction. In futures trading, this is called a retracement. Retracements provide futures traders with a valuable reference point that can be used to predict the occurrence of price turns. They can also help a trader measure the strength of a preceding move.
For futures traders, the most important retracement strength levels are 40%, 50%, 60% and 100%. For example: If the market moves upward 6 price points, then pulls back 3 points, it has experienced a 50% retracement. The same holds true if the market declines 6 points, then rallies 3 points. This is also a 50% retracement. Should the market reverse by the full 6 points, returning to its original starting point, a 100% retracement has occurred. Traders call this a double bottom.
Futures traders can use the strength of a retracement to gauge the strength of market movement and predict potential trends. Futures traders use retracement levels as a general guide in making trading decisions and choosing low-risk entry points. If a retracement is shallow, 40% or less, the prior move is considered strong and a counter move should be equally strong. A deep retracement, above 60%, indicates a weak prior move and should garner a correspondingly weak counter move. Futures traders look for buying and selling opportunities at key retracement levels. Learning to identify and trade on retracements correctly is a valuable asset in the futures trader’s toolbox.
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