Although the 0.618 and 0.786 retracements have been used in Fibonacci analysis for quite some time, the introduction of the 0.886 ratio is a relatively new discovery. Although I have discussed the ratio on various websites, such as eSignal’s www.esignal.com and www.esignalcentral.com, in recent years, popularizing its use in the Fibonacci trading realm, I am not solely responsible for its invention. The 0.886 retracement was conceived through my collaboration with Jim Kane.

Jim Kane of www.KaneTrading.com has investigated the whole range of Fibonacci-derived ratio levels for years. He and I have shared many ideas with each other, in an unprecedented fashion, that have advanced the field of Fibonacci analysis as it relates to the financial markets. In my opinion, the 0.886 retracement is one of the finest discoveries in technical analysis in the past 10 years. The retracement is crucial in differentiating harmonic pattern structures and frequently the determining price level in areas of clear support and resistance.

Initially, I showed Jim a few different pattern structures in my attempt to prove that “not all Gartley patterns are the same!” At this time (a few years ago), I was refining each 5-point price structure based on specific Fibonacci alignments. When it came to the 0.886, I noticed many specific commonalities that developed in price structures that accompanied the retracement.

In particular, I realized that the B point within a Gartley-type structure that was less than a 0.618 would almost always exceed the expected 0.786 retracement of the XA leg at the projected completion point. I showed Jim this new pattern -- called "the Bat" -- which used what I was calling a “deep 0.786 retracement.” I told him that executing at the 0.786 without regard to the structure was a critical mistake. Besides, the 0.886 retracement, when used in the correct pattern structures, reduced the amount of risk in previously “undifferentiated” Gartley set-ups by 10 percent.

I showed him the relationships between the “deep 0.786 retracement" (0.886) and the 1.618 XA projection in the Deep Crab pattern. After we discussed the ideal Fibonacci alignments for the Bat versus the ideal Gartley pattern and in the Deep Crab, he said to me, “The deep 0.786 is really an 0.886 retracement, the fourth root of the 0.618 or the square root of the 0.786.”

Although I defined the price structures and basic Fibonacci alignments for harmonic patterns such as the Bat, Crab and Deep Crab patterns, I want to recognize Jim for his tremendous contribution to Harmonic Trading and for quantifying the 0.886 retracement.

Jim and I agree that it is the most effective Fibonacci ratio in the entire Harmonic Trading arsenal. The 0.886 Fibonacci retracement is frequently the determining price level in areas of well-defined support and resistance. Valid reversals in patterns such as the Bat frequently turn precisely at the 0.886 retracement within the Potential Reversal Zone (PRZ). Although these considerations will be covered later in this article, the 0.886 retracement is an unprecedented discovery that is vital to Harmonic Trading techniques.

I use the 0.886 retracement when day trading the Standard and Poor’s 500 mini-contract (ES). The ES frequently reverses at distinct 0.886 retracements and defines short-term support and resistance. A recent example of the effectiveness of the 0.886 retracement occurred during an entire week of trading in mid-January 2004. The mini-contract trended steadily higher throughout that week, rallying at three, consecutive, 4-day 0.886 retracement levels.

This first chart on the March 2004 S&P 500 mini-contract (ES H4) shows the first three-day 0.886 retracement that began on Friday, January 16th, and completed on the 21st. Although this time period included the weekend, the measured retracement was three full trading sessions. The ES reversed sharply after testing this support measured at 1133.16 exactly. The low was less than ¾ of a point -- 2 full ticks -- below the projected completion at 1132.75.

The low on the 21st at 1132.75 marked the starting point of the second three-trading session retracement. Although the ES reversed 3 ticks shy of the projected completion point, the 0.886 retracement clearly indicated the short-term cycle support.

The final three-trading session 0.886 retracement occurred between January 25th and 28th. Although this third 0.886 retracement yielded a nice short-term rally -- a ten-point bounce, the price action reversed sharply and violated the previous 0.886 retracement. This situation exemplifies the significance of such repetitive cyclical behavior, providing critical information regarding the state of potential future price action.

In the case of the ES, this three-session cycle of 0.886 retracements defined the 1137.55 area as critical for the continuation of the current up trend. After the ES violated this level, the price action was definitely signaling a change in the short-term direction.

This example of 0.886 retracements clearly demonstrates its effectiveness as a critical technical price measure. Although the 0.886 retracement is probably the most effective ratio within the Harmonic Trading approach, the measurement is most effective in the validation of price patterns such as the Bat and the Crab.

The 0.886 retracement can be easily added to the Fibonacci retracement tools within eSignal’s Advanced Charting by accessing the “Lines” heading in the toolbar menu. After opening this menu, you must select the Fibonacci retracements to activate the measurement tool.

As I have illustrated in the previous charts, it is critical to click on a distinct low and drag the cursor to the high point. This will measure the desired range of the price action. After defining the range, right click on one of the lines to edit the retracement levels. This will open a dialog box to input the 0.886 retracement (make sure the button is clicked “ON”).

As I said earlier, the 0.886 retracement is relatively new to the technical community. It is a powerful retracement among the Harmonic Trading measurement techniques that can effectively define the state of future potential price action. The 0.886 retracement is becoming increasing popularly, and those who understand its significance realize that it is more than just another Fibonacci ratio.

*Reprinted (and modified) with permission from HarmonicTrader.com