Fifty percent retracements are important because they balance the net inequality between the competing net order flows [...] Fifty percent retracements happen because once enough buyers square off against enough sellers, only half of those contracts will be profitable. At the 50% number, exactly half the bulls have a profit and half the bears have a profit. When I say this, it is important to note that this is a net perspective. The actual result to any one trading account isn’t the issue. If you could find a way to look into the total number of open trades, you would see that of the sum total of the open longs, about half of that total number of open contracts will have an open-trade profit—the others will have losses. In other words, if there were 10,000 open longs, around 5,000 of them will have some open-trade gain and the other 5,000 will have some open-trade loss. The exact same situation will be accurate for the shorts. The market is now temporarily balanced from the net perspective. This situation won’t last long; it will only take a short time for new buying or selling pressure to come in. Whoever has the net advantage at that point will tip the balance. Most of the time it is in the original direction back toward the previous high or low because from the net perspective the late loser entered from the short-term trend—that is, the few days or so just before the 50% level is reached.
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» You can make a fortune following this one rule alone. «
W.D. Gann - The Tunnel Through the Air, 1927 |
This is a factor of the Rule of 72. Most market participants operate on a time frame of 72 hours or less. That means that in all the various ways of creating a market timing signal that now is the time to initiate a position, most traders have gotten at least one signal in a 72-hour period and have executed, creating net order-flow. Once they have initiated, they must liquidate to accept their open-trade profit or loss. Most methodologies will have given the exit signal within that time frame as well, with the net result that almost everybody has gotten in and out at least once within a 72-hour period. If this process happens at a 50% balance point, the net result is usually a resumption of he previous trend.
How to use the rule: First you must select a significant high or low price previous to the price the market is currently retreating from. When I say significant price I mean a price that is around 72 bars back in time; also they are usually weekly, monthly, or daily price points. If we use a bullish scenario, you are looking for a previous important low price and the market is retreating from the most recent high. If you use a daily chart, your previous low price must be about 72 days/bars back or so, I find that on longer time frames anything substantially less is not as accurate, and anything significantly more is usually ignored by traders as “old data.”
Place a 50% retracement study between the old low and the new high—that would be your best buy point. That point will be some time in the future that approximately reflects the 72-bar ratio. This is why a price could trade to a high. The opposite would be a sell point if you were tracking a rally in a bear market. But the underlying psychology behind the 50% retracement is not about resumption of a previous trend or a failed reversal; it is about the late trader who entered in the last 72 hours.
Most people who initiate a position—about 80% of the total warm bodies sitting in front of a trading screen—are going to do at least one full round turn in the market just prior to the market reaching the 50% price area. The vast majority of those traders are looking to make money right now. If they follow standard technical analysis or use any of the most common methodologies, because the market was trending lower for more than 30 bars from the rejected high to the 50% point, they are looking to sell into the market and join the apparent downtrend currently in progress, from their point of view. Their focus is to get positioned on the short side because “the trend is your friend.”
But the market has just become balanced momentarily. That means only one thing. The shorts from above the market will cover; they have the most recent 72-hour open-trade profit. The late shorts cover, adding to the buy order imbalance as they take their loss. Last, the old longs on the greater-than-72-bar time frame (the 20% of long-term traders, the ones who know how to follow this rule—the professionals who know you need more than 72 hours to beat the loser) add to net winning open positions, many of which they have owned since the turn under the market. They know that the retracement is coming and it will draw in late blood. So they gladly sit through the 50% retracement with at least part of their original position. Of course, the exact opposite scenario develops when a declining market rallies 50%.
Now obviously, markets don’t always turn on a dime once they retrace 50%. Sometimes they take more time to balance temporarily; sometimes they need several more or fewer bars than 72; sometimes they sit at the 50% level for a bit and then retrace farther before moving back in the original trend. None of that is the point. The point is, if you want to make a lot of winning trades and keep it simple, enter your position at the 50 percent retracement point and wait. More often than not you will get at least something you can work with.
