When a market makes a move in any direction it tends to slow down or lose momentum at some point prior to moving in the opposite direction for a period of time, before the previous trend is resumed. These counter trend moves are known as retracements and may occur when a market is moving either up or down.

The reason they occur at all is that traders are never in unanimous agreement about the direction of the market and the opinions that matter; orders entered into the market reflect that disagreement. The upper hand is gained by those trading with the trend but that is almost always subject to temporary reversals.

Let's argue that a bottom is in the market and a rally begins. Price action moves up to a previous area of selling and a reversal occurs. Some of this selling will be short-term profit taking while some will assume that the former down trend is still in play. The net result for the time being is that sellers have overwhelmed the buyers at this point and the market retraces some of the gains it has made from the low. However in our example, the trend still happens to be up and more buying occurs leaving the retracement area behind and new highs are targeted.

Good technical traders are obsessed about measuring everything. They take measurements of price moves and compare them with other price moves. They measure the time a swing takes to go from high to low, low to high, high to high and low to low. They also measure how much a market retraces its former move as a percentage.

Smaller retracements are a sign that most traders are in agreement about the direction of the trend. Deep retracements are a signal that not all traders are certain that a new trend has been established and the starting point is being tested to ascertain the convictions of the market participants. These retracements are measured as percentages. Typically traders watch for ratios based on the Fibonacci number series such as 0.236, 0.382 and 0.618. These ratios may be expressed as percentages. For example 0.382 is expressed as 38.2%.

There are additional ratios to watch out for too, some based on Fibonacci such as 0.786 and 0.764 as well as the 50% ratio. If you subtract the 0.236 ratio from 1.000 you will end up with 0.764 and 0.786 is derived from the inverse of the square root of 1.618. The pocket calculator is a trader's friend as are spreadsheets but retracements are so well known now that most charting packages have a retracement tool to make this type of analysis easy.

One more ratio to watch out for when the market makes a deep retracement is the 0.866 or 86.6 retracement level. This is derived by dividing the square root of three by two. While we are on the subject of square roots, the 50% retracement could be viewed as the inverse of the square root of four.

I've talked about internal retracements so far. That is retracements that are measurements less than the distance of the previous move. You could view moves that retrace the entire amount of the previous move as 100% retracements or as they are more commonly known, double tops or bottoms. Moves that retrace greater than 100% are known as external retracements and are less well utilised by traders.

External retracements may make moves based on Fibonacci ratios greater than one such as 1.382 or 1.618. Recently I observed a beautiful 1.618 external retracement in the Australian Dollar Japanese Yen cross that was a mere half pip from being perfect. With knowledge of external retracements these opportunities won't be missed by sharp traders who do their work diligently.

I highly recommend you start measuring these external retracements for yourself and add them to your toolbox. Both internal and external retracements are important areas on a price chart to watch for potential turning points. They offer strong potential for early entry into new trends or opportune entry points on existing trends with the benefit of your being able to make use of tighter stops to lower risk.