Calculating Retracement And Projection Levels

Calculating Retracement and Projection Levels

Questions and suggestions? Contact me at [email protected] Charts were generated using MetaTrader 4.0 from Alpari UK

Technically Speaking – Andre Setiawan

Calculating Retracement and Projection Levels Step 1: Spotting Significant Highs and Lows On my published analysis you might have seen lots of lines and numbers corresponding to what I referred to as retracement levels and projection levels. For those who are still relatively new to chart analysis, retracement levels are the price levels that are expected to be reached when a full swing has come to an end and the price enters the correction phase. Requirements for calculating retracements are simply a significant low point and a significant high point which represent a full swing up or down. Now, how to pick these two points from the chart will probably differ from one person to another although in some cases there will be uniformity in the selection.

Take a look at the AUDUSD chart above. The red circles marked what I define as ‘significant’ highs and lows. Other observers may come up with different highs and lows but that should not be a major problem because there is no fixed rules on how to set these significant highs and lows. My selections of these highs and lows however, have similarities in that each marked point has higher lows on its left and right (for a significant low) or lower highs on its left and right (for a significant high). In theory, these are called fractals. While a significant high/low is always a fractal high/low, a fractal high/low is not necessarily a significant high/low.

Technically Speaking – Andre Setiawan

Now that you know how to spot fractals, you should be able to spot significant high and low points as well through practice. To reiterate, there is no rigid rule on determining significant high and low points on the chart.

Technically Speaking – Andre Setiawan

Step 2: Measuring Retracements / Corrections Next is to calculate the retracement levels of a full swing. To do so, we use the Fibonacci numbers 0.236, 0.382, 0.5, 0.618, and 0.764. I will not elaborate on how these numbers originated because it would serve minimum benefits. The term ‘full swing’ means a straight move from one significant high to the next significant low (in a downswing) or a move from one significant low to the next significant high (in an upswing). Referring to the AUDUSD chart, a move from A to B is an upswing, B to C is a downswing, and C to D is an upswing, and so on. To complicate the topic, two consecutive upswings could become one upswing of a higher degree. From C to D we have an upswing, followed by a downswing of D to E, and then another upswing from E to F. This sequence C-D-E-F creates a larger degree upswing C-F in the form of a zigzag pattern. Similarly, from F to I a larger degree downswing could also be observed. This FI downswing consists of FG downswing, GH upswing, and HI downswing. The structure of FI is also a zigzag pattern. When one swing completes, regardless of its degree and size, a reaction occurs in the form of a retracement, or correction. This is where the Fibonacci numbers are being used. For example, take a look at the zoomed version of the previous chart:

Technically Speaking – Andre Setiawan

Swing low C is at 0.8947, and swing high D is at 0.9079. Once we are able to identify these points, we can calculate the retracement levels where the next swing low will be. The distance from C to D is 0.0132 (0.9079-0.8947). We apply the Fibonacci numbers by multiplying every one of them to 0.0132 and subtract each result to 0.9079. If the full swing is up, we subtract from the top; if the full swing is down, we add from the bottom. To illustrate, 0.236 * 0.0132 is 0.0031. So, the 23.6% retracement of swing CD is (0.9079-0.0031) or 0.9048. Following the same method, we multiply 0.382, 0.50, 0.618, and 0.764 as well to 0.0132. The results can be seen on the chart: 0.9028 (38.2%), 0.9013 (50%), 0.8997 (61.8%) and 0.8978 (76.4%). Swing point E turns out to be at 0.9024, or slightly below the 38.2% retracement level (0.9028). Fibonacci retracement levels are rarely precise. There used to be some minor deviations to the final results as seen on the example where the expected low of 0.9028 turned out to be at 0.9024, a 0.0004 below the expectation. This is why Fibonacci retracements should be used as reference rather than setting it as a rigid way to establish trading positions. In addition, to make matter worse, there is no way we could know beforehand at which retracement level a correction will stop. From our example, E could have been anywhere, the retracement could have gone to as low as 0.8978. However, knowing how to calculate the retracement levels can be handy in setting up trading strategy later on. I cannot explain that yet, because it will be too complicated at this stage. One thing that could be useful once we know point E, is that we could somehow gauge the strength of the upswing or the downswing. Retracement of 50% suggests a normal strength, which could lead to anywhere, up or down. If a swing retraces by 23.6% or 38.2%, a continuation of the previous direction is to be expected as the power of the swing is strong. The larger the correction, the weaker the swing will be. From the example, upswing CD could be considered strong as it simply retraced by 38.2%, thereby it should not be a surprise when the price rallied above point D afterwards. Next, once we have identified point F as the next swing point, we could calculate the retracement points of the upswing EF. At the same time, as mentioned before, two upswing could make up a single upswing of higher degree. So, in addition to the upswing EF, we can also calculate the retracement points of the upswing CF. In reality, after AUDUSD reached F at 0.9121, it fell below E and kept falling until it reached 0.8982 which later was marked as swing point G. This means the upswing EF had been fully retraced. The retracement levels calculated from E to F had expired. This in turn, shifted the focus towards the larger degree upswing CF which had its own retracement levels. One of them is 0.8988, the 76.4% retracement level. The fall in AUDUSD stopped just below 0.8988 at 0.8982 or 0.0006 lower before the price climbed back. After the low at G has been established, we calculate the retracement levels from the downswing FG. As the direction of the swing was down, the results of the multiplication were added to 0.8982. To illustrate: FG’s length was 0.0139, and 0.236 * 0.0139 is 0.0032. So the low at 0.8982 is added by 0.0032 which turned out to be 0.9014. This is the 23.6% retracement level of the downswing FG. Following the same procedure we obtained 0.9035, 0.9051, 0.9067, and 0.9088. Remember, at the moment we have all these retracement levels calculated we did not know at which one the upward correction would stop. In fact, it is impossible to know it beforehand. We could have thought that it would stop at 0.9035 just like the swing CD, but it turned out to stop at the highest retracement level 0.9088. Swing high H was 0.9090, a mere 0.0002 higher than the expected 0.9088. AUDUSD immediately fell after hitting H and at the beginning of the next hour after the point H was reached, we could begin to see that H was our new swing high. We could have interpreted downswing FG as a weak downswing, but a rapid decline from H should be able to erase such impression. This is

Technically Speaking – Andre Setiawan

why it could be said that there is no fixed rule in price forecasting. Nothing is certain until the market says so. This should conclude the second step in understanding my written analysis, mainly on how I came up with those lots of numbers and lines on my charts. The first step to know is to be able to identify the significant turning points/swing points on the charts, and the next step is to know how to calculate the retracement/correction levels based on the Fibonacci numbers. Step three will be how to use Fibonacci numbers in making projection targets of zigzag patterns.

Technically Speaking – Andre Setiawan

Step 3 : Identifying Zigzags Zigzags are an important aspect to know before we proceed towards calculating projection points. From the previous illustrations, once you knew how to spot significant highs and lows, spotting zigzag structure will not be something hard to do. A zigzag structure involves FOUR consecutive alternating turning points/fractals. A rising zigzag consists of a LOW-HIGH-LOW-HIGH sequence while a falling zigzag consists of a HIGH-LOW-HIGH-LOW sequence. Let’s label the first turning point as A, the second as B, the third as C, and the fourth as D. A valid zigzag has another requirement to be satisfied. In a rising zigzag, Point C MUST be ABOVE A, while point D MUST be ABOVE B. Of course, the logic is simple, we cannot call a structure as rising if there is no progress signified by higher high and higher low, can we? Rising zigzag is actually an illustration of the concept of TREND. An uptrend is characterized by a set of higher highs and higher lows whereas a downtrend is characterized by a set of lower highs and lower lows. In a falling zigzag, point C MUST be BELOW A, while point D MUST be BELOW B.

Take a look again at the above illustration. C-D-E-F is an example of a rising zigzag, with E>C and F>D. F-G-H-I is an example of a falling zigzag where HA, F
Technically Speaking – Andre Setiawan

case, we can identify a new zigzag: BCFI. BCFI consists of smaller zigzags CDEF and FGHI. At this point, things may confuse you a bit. Just re-read and observe the illustration and I believe you will eventually understand it. Step 4: Making Projections Projections based on Fibonacci numbers are made only when we have identified the first three turning points in a zigzag. The fourth one, D, is the subject of the projection. Usually there are three numbers used in projecting point D: 0.618, 1.0, and 1.618. In a rising zigzag, we first measure the length of AB. Next, we multiply each of the three numbers to the length of AB. Afterwards, we add each of the results to point C.

For example, look at the zigzag CDEF. Assuming that we have not reached F yet, we can estimate at around where F may be located. Recall that C = 0.8947, D = 0.9079, and E = 0.9024. Using three commonly used numbers 0.618, 1.0 and 1.618, we multiply each of them to the length of C to D which is 0.0132: 0.0132 x 0.618 = 0.0082, 0.0132 x 1.0 = 0.0132, and 0.0132 x 1.618 = 0.0214. Next, we add each of the results to point E because the zigzag is a rising one: 0.0082 + 0.9024 = 0.9106, 0.0132 + 0.9024 = 0.9156, and 0.0214 + 0.9024 = 0.9238.

Technically Speaking – Andre Setiawan

So, we have 0.9106, 0.9156, and 0.9238 as the projected location of F. In reality, F was at 0.9121, a bit above the 0.618x projection. Similar to retracements, projections are mostly deviating from the expected level by some points, but it is important to know how to calculate these projections. Moving on to the second example, we have to assume that we have not know yet where point I is located and want to calculate it using the projection method. So, we will need the points F, G, and H first. F = 0.9121, G = 0.8982, and H = 0.9090; FG = 0.0139; 0.0139 x 0.618 = 0.0086, 0.0139 x 1.0 = 0.0139, and 0.0139 x 1.618 = 0.0225; Next is to SUBTRACT (because the zigzag is falling) the results from H: 0.9090 – 0.0086 = 0.9004, 0.9090 – 0.0139 = 0.8951, and 0.9090 – 0.0225 = 0.8866. In reality, point I was located at 0.8915, right in the middle of the 1.0 and 1.618 projection targets. We are not done yet with projecting point I. In addition to the above calculation, point I can be forecast by using points B, C, and F. After all, it is also a valid zigzag. First we find the length of BC which is 0.0233, multiply the three numbers to it, and subtract the results from F (0.9121) because it is also a falling zigzag. Using the same method like above, we finally come up with the projections at 0.8976 (0.618x), 0.8886 (1x), and 0.8742 (1.618x). This means point I has six possible levels: 0.9004, 0.8976, 0.8951, 0.8886, 0.8866, and 0.8742. Recall the rule that in a falling zigzag, the second low must be below the first. From our example here, in order to be valid, point I must be below G, therefore any projections which are above 0.8982 will be eliminated because they are not valid. Thus, 0.9004 is automatically eliminated although at a glance we could see that the price bounced off this level before it went down again. The same goes with the larger projections based on BCF, we eliminate 0.8976 because that would not make a lower low as point I > point C. After filtering out the invalid levels, we end up with just 4 projection levels: 0.8951, 0.8886, 0.8866 and 0.8742. At this point one may argue that 0.8951 is actually higher than point C so that it should have been eliminated as well. Well, this is a choice, but we should not forget that 0.8951 is projected using FGH zigzag, NOT BCF. Therefore there is no obligation that it must be located below C. I know that grasping this subject for newcomers may be too much, but with practice and routine observations of the charts, one can eventually understand it. It is actually very simple compared to other methods. As a reminder, do not be discouraged when the analysis turns out to be different from other people. This is not an exact science, and this is a totally subjective matter. One cannot judge another beforehand because in the end, the market is the jury. What is needed is persistance to learn and practice. By now, at least you should already know how I came up with my analysis. Sometimes I am correct, sometimes I am wrong. Although past accuracy will not guarantee future accuracy, as we gain experience from past analysis, our performance should become better as we learn more and more about the market. Good luck!

Technically Speaking – Andre Setiawan