Dan Hassey: One of the best predictive tools of technical analysis (the study of price action) is what’s called a “retracement.”
Normally after the market makes a move (up or down), prices either consolidate or retrace. Let’s look at the S&P 500 index over the last few years.
Here are some key points from the chart above.
- The current major bullish trend began in November 2012.
- Prices rallied until February 2013, then entered a narrow 1,500-1,525 range.
Most consolidations are only a pause within a trend. The pause or consolidation period keeps prices in a narrow range for anywhere from a month to up to three months.
The previous trend resumes when the consolidation period is over.
- When the S&P 500 rally resumed, it rose a bit then consolidated again in March. This period is important because the index established good support at the 1,540 level.
- The rally resumed until entering a retracement phase in May/June 2013.
By definition, a retracement reverses a portion of a move, normally 38%, or 50%, or about 62%.
In this case, the S&P 500 retraced 38% of the November 2012 — May 2013 rally.
Now let’s roll the chart forward and see where we are now.
- The next two moves in August and September 2013 also ended with retracements.
- The move that started in October did consolidate in a narrow year-end range from around 1,775 to 1,810.
- In January, it looked like the next move would be a consolidation, but the index finally broke down and retraced 38% of the October 2013 — January 2014 rally.
Monday’s downdraft sent the S&P 500 below the 38% and 50% retracement level, but stopped before marking a 61.8% retracement.