Retracing Yen

10/12/05 07:55:12 AM

by David Penn

Using Fibonacci to gauge pullbacks in the USD/JPY.

Security: USDJPY
Position: N/A

Last night, I found myself eyeballing the USD/JPY. A powerful move to the upside had begun in the hourly charts in recent days, and I was looking for opportunities to get long. At the time I began watching USD/JPY, it had already broken out above the 114 level to 114.31, and had begun to shrink back slightly.

The question for any buyer when it comes to pullbacks is straightforward: How far "back" does the asset need to "pull" before it is buyable? For some traders, particularly those with a more conservative approach to trading, the solution--as opposed to the answer--to this question is no less straightforward: You wait until the previous high is exceeded by a tick or two. But those with a somewhat more aggressive attitude will want to buy the asset as low into its pullback as possible.

FIGURE 1: USD/JPY. After stalling temporarily at 114.31, the USD/JPY retraced back to the 38.2% Fibonacci retracement level before vaulting higher.

Graphic provided by: eSignal.

My first thought in terms of likely support at USD/JPY moved down from 114.31 was the breakout high back near ... well, where exactly? Was the breakout down at the 114 level (Figure 1)? Or was it even lower at the 113.85/90 level?

Some traders consistently disregard the long tails or shadows on candlesticks. I tend to think this is a mistake unless your trading approach is only concerned with closing prices. If you are willing to let an individual bar or candlestick run for as far as it likes, only concerning yourself with where it closes, then so be it. However, if you use stops that aren't closing-price based, it seems to me that every print is important, and long shadows and tails on candlesticks--at least up to a point--need to be taken seriously.

Fortunately in this case, traders don't have to quibble over where the proper breakout level was in the USD/JPY. Instead, they can rely on Fibonacci retracements to gauge likely levels where the post-114.31 pullback might be likely to find support.

While the minimum pullback is usually thought to be 25% or 0.25, a pullback to the 38.2% or 0.382 level is generally considered to be a typical pullback in a healthy advance. A pullback to that level is a little more than a third retracement, and often that much of a retracement is enough to take some of the steam out of the trend, allowing some (weaker) traders to get out of positions and others to get in. As John Murphy wrote in his book, The Visual Investor:

Usually a market will retrace a minimum one-third of its prior move. A rally from 30 to 60 will often be followed by a 10-point correction (one-third of the 30-point gain). This minimum retracement tendency is particularly helpful in the timing of purchases or sales. In an uptrend, an investor can determine in advance where a one-third retracement lies, and use that level as a potential buy point. In a downtrend, a one-third bounce could represent a selling area.

As Figure 1 shows, the 38.2% retracement level proved to be an excellent level for a short-term bull to establish a long position, as the USD/JPY pulled back to an hourly low of 113.77--a mere four pips below the 38.2% retracement level--before moving sharply and swiftly higher over the next several hours.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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