Option Investor

Daily Newsletter, Wednesday, 08/08/2007

Printer friendly version

Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Trader's Corner

Market Wrap

The Bulls Hold It, Maybe

For most of the day it was looking like the bulls were going to carry the day and keep the bears in their caves. Even though the Fed did not sooth the market's worries and even though bonds sold off, driving rates higher, the bears just weren't able to do much today. But then by the latter part of the afternoon the bulls were wondering who ate their rally as the DOW coughed up 200 points and sunk back into the red. Then it was time to jam the shorts into the close as they rallied it 130 points off this afternoon's low. Like I said before, if you like volatility to trade then you've got to love this market.

The market may very well have found a bottom at Monday's low and away we go for new market highs but that's not the way I see it. We might get a larger rally, in time and price, but the setup was a very good one to get short at today's high. I've often mentioned the personalities of the different waves. On the charts that I've been posting, including last night's, with the bearish wave counts (dark red on the charts), I've been looking for a 2nd wave correction to the decline from the July high. The personality of 2nd waves is that they get the opposite side all excited that the correction is over.

In this case the bulls think the decline was a correction of the longer term rally and that this week's rally was the resumption of the uptrend. But the decline off the July high was a sharp 5-wave move down which says we have to be on guard for what may have been a true reversal of the uptrend. So in this case the bulls are thinking the longer uptrend is still intact and this week's bounce therefore has most thinking the rally is real. The 2nd wave corrections are therefore often the trap and in this case it could be the bull trap.

We won't know until we see it in the rear view mirror whether this week's rally is the start of a stronger move up to new highs or just the correction of the decline. So we trade according to our belief about where we think the market is headed next. And I use EW (Elliott Wave) analysis as one of the tools to help me figure out what's next. I'd prefer to do hindsight trading but I'm still working out the bugs on that method.

Today's bounce took the market up into the Fib resistance zone and I was watching the DOW and SPX for where the bounce off Monday's low would have two equal legs up. This provided a Fib resistance zone, for example, of 13686-13707 for the DOW and I made a strong recommendation to short it there on today's Market Monitor. The DOW's high was 13695. We will only know tomorrow if it was a good call or not but at least those who took the trade know where their stop belongs--just above today's high.


Earn $2,000 Each Month with a Conservative Options Strategy

We will show you how you can make $2,000 in cash each month using your existing portfolio equity as collateral. This low-risk strategy works no matter which direction the market goes. Best of all, it is easy to implement and no previous experience with options is necessary.

Take a complimentary 30 day test drive. Click Here:


If I've got the wave count correct then we should get some strong selling tomorrow right out of the gate. This is because of the late-day bounce into the close. If that bounce was just a correction of this afternoon's decline then it needs to sell off immediately tomorrow and a 3rd wave down should have some punch to it. Any further rally would obviously negate the short term wave pattern and I'll show the possible scenarios in tonight's charts.

It was another quiet day as far as economic reports:

Economic reports
Wholesale inventories and crude inventories, that's it. And neither one moved the markets.

Wholesale Inventories
U.S. wholesalers' inventories rose by +0.5% for the second month in a row in June. This was helped by rising stockpiles of petroleum since sales of petroleum declined in June, down 1%. But for the past year inventories are up +6.3% while sales are up +8.1%. Petroleum sales are up +9.4% for the past year while inventories are up only +2.4% so there's been a drawdown in those inventories.

These numbers are typically not market moving since they're only used by the bean counters to help them tweak their GDP numbers.

Crude Inventories
Crude supplies fell 4.1M barrels to 340.4M and gasoline supplies fell 1.7M barrels but distillates rose 1M barrels. Refineries had a 91.3% utilization rate.

Some other news that came out this morning included a tit-for-tat exchange with China. The U.K.-based Telegraph reported that China may liquidate its huge holdings of Treasuries if Washington continues to pressure China to revalue the yuan higher sooner rather than later. China holds the trump card in my opinion. There's no way we can afford to have a massive selloff in our Treasuries. Hello 8% (or higher) rates if that happens.

Or course China literally can't afford to cause that to happen to the U.S. otherwise it'll immediately drive us into a recession. That would cause the U.S. consumer to stop spending and where do you think all our spending goes? China. Their huge trade surplus would instantly evaporate and all the construction programs they're trying to support would collapse and they'd have a riot on their hands from disgruntled citizens who can't find work.

China is saber-rattling in an attempt to get our Congress to stop with the protectionist talk (which I agree with--we have a bunch of financially illiterate Congressmen and Senators who clearly haven't studied the lessons learned from the last Great Depression). As T.J. Marta, a strategist at RBC Capital Markets said, "The U.S. and China are engaging in mutually assured economic destruction." Let's all hope for both of our sakes that cooler heads will prevail. We need to take Congress' finger off the button and Treasury Secretary Paulson needs to take a chill pill.

One of the difficulties for us, with higher rates, will be an exacerbation of the credit problem. And that would cause Jim Cramer to have another hissy fit. In fact he might have a heart attack and we don't want to cause him that kind of problem. The subprime mortgage problem has clearly spread to other mortgage loans, contrary to the assurances we received from our Fed, Treasury Secretary, and Jim Cramer himself. I always thought it was a slam dunk that all mortgages would be affected since the tightening of credit standards would ripple through the entire system. Sometimes I think economists think too much about a problem instead of using common sense.

At any rate, the problem is now spreading into corporate loans. The plethora of high-risk loans that have been made to businesses, including the covenant-lite loans, are coming to a screeching halt. That is of course making it more difficult for all businesses to sell their debt. Unless you're a GE with honest-to-goodness AAA-rated bonds, the bond market has about locked up. Mergers and acquisitions (M&As), leveraged buyouts (LBOs), private equity buyouts and stock buybacks (with borrowed money) are coming to a halt. This is what has so shocked the stock market bulls and the problem didn't suddenly go away this week. In other words, look at bounces in the market as gifts to get out of long positions and get short instead.

This lack of ability to sell debt is part of what I've been warning about when I said the credit bubble will likely collapse at a high rate of speed. I think it's starting off relatively slowly but will probably pick up speed as more and more bonds are downgraded and more sales are forced on fund managers. The process of going from mark-to-model to mark-to-market has only just begun. David Kotok, chief investment officer at Cumberland Advisors says "It's in the hundreds of billions, perhaps trillions affected. It has got to be repriced to reflect a market-based pricing system. That is a process in which there will be losses, and the markets know it. They just don't know how big it is and who it hurts the most." I think Jim Cramer knows who's getting hurt.

Cramer wants the Fed to help the situation by cutting interest rates. But if the Fed announces that it plans to make money cheaper by cutting rates, the cycle of easy-money lending, with investors ignoring credit risks, could start all over again. So the market will have to deal with wringing the excesses out of the system and most know it will be painful, or at least they're afraid it will be painful. Moody's says corporate defaults will more than double in the coming year as widely available, cheap credit dries up. They figure the global speculative-grade corporate default rate should rise to about 3.5% from a current level of 1.5%.

So the subprime problem is a lot bigger than mortgages and in fact has touched just about every phase of credit financing. We've seen the largest credit bubble built in just the past few years with nary a worry about the consequences (as always happens in a bubble). The consequences will very likely drive us into a recession (or worse) before the system is cleansed of the excess and waste. It's a necessary, albeit painful, process and my hope is that it corrects quickly rather than drags out for the next 10 years.

That should answer the question very clearly as to why I'm bearish the stock market. It doesn't mean I'm all doom and gloom or a pessimist. It means I recognize a bubble when I see it. It means I'm using technical analysis to tell me we're at a very critical and vulnerable point in the stock market. We're near the point of recognition that the economy is going to suffer and therefore so too will the stock market. Our job as traders is to get on the correct side of a trend. The earlier we can recognize when a trend is changing and switch with it, the better will be our trading results. And that is what I'm trying to do. So with that let's take a look at today's charts.

DOW chart, Daily

The correction against the decline from the July high can be satisfactorily counted as complete. The 2nd wave correction (labeled wave-2 in dark red) typically takes longer than what we have so far and for that reason, as well as the deeply oversold market conditions, bears need to stay alert to the possibility that we're going to see a choppier price pattern work its way higher before it finishes. In fact the daily chart of the RUT gives me the impression that that's what we should expect. But if the sellers take hold of this market tomorrow and we get a strong down day then it will be a heads up that we've may have seen the high for the correction.

The bullish possibility is that we'll see the DOW head higher than 13800 to recover its broken uptrend line from March and get above a 78.6% retracement. If it takes us into next week before we see that level then it still leaves open the possibility that we're only in a larger 2nd wave correction, as shown in pink on the 60-min chart:

DOW chart, 60-min

As I had mentioned last night, there are several possibilities for the corrective bounce (which I think this is) and I'm only showing a couple of possibilities on the chart. The most bearish one is that we'll see early and hard selling tomorrow (dark red). If the deeply oversold market needs more time to work off the oversold conditions then we might get a pullback and then another leg higher as part of a larger A-B-C rally for the 2nd wave correction (pink). The bullish possibility is that we've finished the pullback correction and we're heading to new market highs now.

Another possibility that I show on the NDX 60-min chart below is for an A-B-C bounce that started from last Wednesday's low. That interpretation calls for one more high and in that case we could see the Fib projection at 13708 get tagged (this is where the 2nd leg up = 162% of the 1st leg up last week). So if anyone shorted today's high (as I had called out on the Market Monitor) and gets stopped out with a move higher tomorrow morning, then be ready to hit it short again at a minor new high.

SPX chart, Daily

I had mentioned last night that SPX 1506 will likely be resistance. Today on the Market Monitor I further refined my upside projection and said 1505 would likely be resistance (along with the Fib resistance zone for the DOW between 13686 and 13707). Today's daily candlestick looks like a bearish shooting star at Fib resistance but it needs a red candle tomorrow to confirm.

I show two possibilities from here--the bearish wave count (dark red) calls for an immediate decline whereas the bullish (green) count calls for a continuation of the rally. In between, and shown on the 60-min chart, is for the possibility for a pullback and then another rally leg as part of a larger A-B-C bounce off Monday's low. I had recommended a short play against today's high and it's possible we'll get one more minor high but the 1506-1507 area still holds the potential for a top to the bounce and will be worth testing with a short play again.

The more immediate bearish possibility is that today's high marked the end of the bounce and the fast drop this afternoon was the start of the next leg down. We got a strong short-covering bounce into the close but if that was only correcting this afternoon's decline then tomorrow will see selling out of the gate that gets very strong.

SPX chart, 60-min

The late-afternoon rally into the close can be seen by the last white candle. It was a bout of short covering into the close and quite frankly looked too engineered. Whether it was the PPT or the major banks goosing the market to help their hedge funds (in order to compensate for the creaming they're getting in their mortgage-related funds), it looks false. But if the buyers manage to push this to a minor new high tomorrow morning, short it. The setup is good for a short play. Whether it will turn into a hard selloff (dark red) or just a pullback before proceeding higher, it should be a good trade on the short side.

Nasdaq-100 (NDX) chart, Daily

I had pointed out last night that a push up to NDX 2004 would be a good setup for a short play. It came close but didn't quite make it there today. I still like that level for a short if it gets tagged tomorrow morning. It's possible to consider the bounce as finished and therefore any early selling tomorrow could pick up some speed.

Nasdaq-100 (NDX) chart, 60-min

This chart shows the possibility that the correction to the decline from the July high actually started from last Wednesday's low (dark red A-B-C). That's why I liked the 2004 level for the end of the rally. The risk for those who shorted today's rally is that we'll see the NDX tag the 2004 level before turning back down in earnest (pink wave count). But I liked the setup this afternoon for a short against the high and will simply take the stop if it rallies a little more and then reenter the short at the next high.

Russell-2000 (RUT) chart, Daily

The RUT is one of the indices that gives me the impression that there needs to be a larger correction (in time if not price). After the steep decline it looks like the current correction is too short in time. So the pink wave count shows an idea for the pullback that will be followed by another rally leg, possibly up as high as the broken uptrend line from August 2006 and the 78.6% retracement at 832.

But this is very likely a 2nd wave correction and the risk for those who are long and wanting out, or bears wanting to get short, is that the market may frustrate both of you. We saw this market in its uptrend constantly frustrate the bulls who wanted a dip to buy and bears who wanted out. A 2nd wave correction is often reversed very quickly and one of the reasons the 3rd wave decline is so strong is because traders end up chasing it down.

Russell-2000 (RUT) chart, 60-min

The 60-min chart shows the possibility for a pullback and then another rally leg (pink) to give us the larger upward correction before the market sells off strongly again. It takes a break below 758 for the bears to start claiming victory.

BIX banking index, Daily chart

The banks continued their rally as well today and managed to get a little above the top of its steep parallel down-channel. The bearish (dark red) wave count still works (it would be negated with a rally above 392) even if the bounce is getting a little long in the tooth. If the wave count is correct, the entire bounce should be erased quickly as price then stair-steps lower.

The home builders got a nice bounce today and it's looking like they're actually going to get a bigger correction of their decline from here. I guess the investors viewed today's report out of the National Association of Realtors (NAR) where they again lowered its forecast for existing home sales for 2007, dropping it to a -6.8% decline in sales, to 6.04M, vs. the previous forecast for a -5.6% decline. The NAR said new home sales are likely to drop -19.0% to 852K vs. their prior forecast for a -17.7%.

I have mentioned in the past that prior home market downturns did not find bottom until new home construction dropped below 1M starts, and 800K-900K has been the typical number. Past surges in home building wasn't as significant as the most recent one and therefore we don't know if the correction will be even more severe but it's interesting that the NAR is forecasting sales of new homes to drop to 852K. With home builders still building 1.4M-1.5M you can see the disconnect.

But home builders had a good rally anyway and very likely the result of some short covering and bottom fishers.

U.S. Home Construction Index chart, DJUSHB, Daily

The 50-dma for the home builders is currently at the same level as the July 2006 low which acted as support/resistance near 547. That might be where the bounce is heading but regardless this index should have lower to go before the pattern can be called complete to the downside.

Oil chart, September contract (CL07U), Daily

If oil consolidates briefly and then heads lower again then we'll get an impulsive decline. That would say we've got a trend change to the downside. But if it can get another rally going then it continues to maintain the possibility to rally up to the Fib projection at 80.67.

Oil Index chart, Daily

Oil stocks looks like they're trying hard to push back above the top of the parallel channel from 2005 and I think they should be able to do it, especially if oil rallies again. But any turn back below 700 will be the signal that the bounce is finished and the next leg down should be take it right down to the bottom of the channel near 640.

Transportation Index chart, TRAN, Daily

The Transport index is another one that gives me the impression that we'll get a larger correction to the decline from the July high. I think a more "appropriate" correction would be a retest of its broken uptrend line from March, up near 5280. But if weakness prevails and this drops back below 4800 then the bounce will simply have been smaller than usual.

The US dollar was under pressure again today as the Bank of Australia raised its key interest rate by 0.25% to 6.5% which is the highest level since November 1996. The Bank of England also reaffirmed expectations that it will raise rates to 6% by the end of the year based on its report on inflation. That resulted in a rally for their currencies and a selloff for the US dollar.

This also increases the yen carry trade where traders borrow the yen to invest in higher-return currencies and is generally supportive of the global stock markets where the money also gets invested. The downside of this is that a reversal of these carry trades is what exacerbates the selling in the stock market.

U.S. Dollar chart, Daily

The US dollar sold off after the FOMC announcement but then recovered some today. If it manages to reverse back up from here you can see it will leave a rather significant short term bullish divergence against Monday's low, and this follows the longer term bullish divergences at the lows.

Gold chart, December contract (GC07Z), Daily

The bounce over the past few weeks has been corrective and looks like a drop waiting to happen. Any drop back below 665 will likely be followed by some very strong selling. A rally above 701 would negate the bearish wave count although I'm not sure it would be immediately bullish. The 60-min chart shows the ascending wedge pattern for the bounce since the July 26th low:

Gold chart, December contract (GC07Z), 60-min

Today gold did a throw-over above the top of the ascending wedge and then dropped back inside the pattern so we have a sell signal. Confirmation would be a drop below the bottom of the pattern and most especially the last low at 677.40. The larger pattern and this short term pattern both suggest that we should see some strong selling in gold next.

Results of today's economic reports and tomorrow's reports include the following:

Tomorrow is even quieter today as far as economic reports--only jobless claims. So the market will be left to fend for itself.

SPX chart, Weekly

Obviously there's not much of a change between last night's weekly chart and tonight's, other than the fact that the white candle for this week is a little bigger. SPX closed less than a point above the mid line of its Bollinger Band (which is just shy of 1497) so a turn back down from here would be typical.

The end-of-day pop into the close sets us up for an immediate decline right out of the gates. That assumes this week's bounce, for the correction to the decline from the July high, finished at today's high and the afternoon decline was the start of the next leg down. That interpretation says the end-of-day rally was a correction to the afternoon decline and now we'll get some early and strong selling tomorrow.

But if we get an early rally instead then it's highly likely we'll see a move above today's high. That raises the possibility that we'll see an early failure of the rally so watch it carefully for a shorting opportunity if it looks like the buyers can't hold it up. Short it against the high and try it once or twice to see if we put in an early high. This will be especially true if we see the DOW fail near its Fib projection at 13708 and at SPX 1506-1507.

Assuming we get a selloff, either right away or after a minor new high, it will then be a matter of determining whether it's just pulling back before setting up another rally leg or instead starts another serious decline. I've given some key levels on the charts to help identify when the market is likely breaking down. Until those levels are violated you may want to keep trading this market instead of holding out for bigger moves. With this volatile market you can still make a lot of money by simply getting in and out quickly after each move (use trend lines on the short term charts). If at any time we see new lows below Monday's then that answers the question as to whether the bounce is finished or not--a break to new lows should move very fast and you'll want to be short.

The bulls will still do some buying (and we'll get the manipulated short-covering rallies) so be prepared for anything. These volatile price swings demand disciplined trading and right now that means smaller positions with wider stops than you're used to. When you feel you're out of synch with the market, wait for another day instead of trying to make up your losses before the market closes. The market is here every day and you can help yourself by trading only when you feel in synch with the market.

Good luck with the whipsaws and I'll be back next Wednesday. I'll be on the Market Monitor tomorrow.

New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
None None None

New Calls

None today.

New Puts

None today.

New Strangles

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Penn National Gaming - PENN - cls: 57.91 chg: +0.84 stop: n/a

If you're feeling adventurous then today's rebound in PENN looks like a potential entry point (maybe with a stop under $56.70) but we're not suggesting new positions. The stock has been displaying way too much weakness given its pending merger and shares will be subject to any sort of headline news regarding the merger's progress. The stock should be trading near its buyout price around $67. The fact that it's not would suggest that the market doesn't believe this deal will get done - at least not in its current form or price. PENN's 45-day window to solicit a higher bid has expired. FYI: We'll be dropping this stock at August option expiration.

Picked on June 17 at $ 62.12
Change since picked: - 4.18
Earnings Date 07/26/07 (unconfirmed)
Average Daily Volume = 1.0 million


Sears Holding - SHLD - cls: 134.17 chg: +1.12 stop: 127.49

We are still urging caution here. SHLD produced a volatile day. The stock spiked to $138.63 and then eventually gave most of its gains back. SHLD did not rebound as strongly as the rest of the market during the late afternoon bounce. SHLD rose 0.8% versus a 1.9% rally in the RLX retail index. We're not suggesting new positions at this time. Right now our target is the $139.50-140.00 range but we're thinking about adding an aggressive target in the $145.00-150.00 zone.

Picked on August 3 at $133.00
Change since picked: + 1.17
Earnings Date 08/30/07 (unconfirmed)
Average Daily Volume = 1.7 million

Put Updates

ITT Educ. - ESI - cls: 100.95 change: -3.40 stop: 107.51

Bears can feel a little bit more comfortable with ESI. The stock displayed a lot of relative weakness today. Shares produced a failed rally near $105.50 and its 10-dma. Plus, the stock produced a bearish engulfing candlestick pattern. The $100 level is still holding as support but ESI did lose more than 3.2% today. Our target is the $92.00-90.00 range. The P&F chart is bearish with an $86 target.

Picked on August 05 at $102.22
Change since picked: - 1.27
Earnings Date 07/26/07 (confirmed)
Average Daily Volume = 491 thousand

Strangle Updates

(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)


DaimlerChrysler - DCX - cls: 88.56 chg: +0.30 stop: n/a

DCX produced a meager bounce after trading near rising technical support at the 100-dma. We are not suggesting new strangles on DCX at this time. The options in our suggested strangle were the August $95 calls (DCX-HS) and the August $85 puts (DCX-TQ). Our estimated cost was $3.70. We want to sell if either option rises to $6.45.

Picked on July 22 at $ 89.75
Change since picked: - 1.19
Earnings Date 07/25/07 (unconfirmed)
Average Daily Volume = 1.3 million

Dropped Calls

Lam Research - LRCX - cls: 58.63 chg: +1.04 stop: 53.90

Target achieved. The SOX index rallied sharply following strength in the NASDAQ (thanks to CSCO). This strength in the semiconductors helped LRCX hit an intraday high of $59.79. Our target was the $59.75-60.00 range. The play is closed for us but more aggressive traders may want to stick with it and aim higher. However, you can easily see on the daily chart that LRCX does have resistance at the $60.00 level.

Picked on August 3 at $ 55.10
Change since picked: + 3.53
Earnings Date 08/24/07 (confirmed)
Average Daily Volume = 2.9 million


PACCAR - PCAR - cls: 81.92 change: -0.88 stop: 79.70

PCAR displayed relative weakness today. The stock spiked to an intraday low of $79.58 and closed with a 1% decline versus a broad-based market rally. Our stop loss was at $79.70 so we would have been stopped out early this morning. A break above $85 could be a bullish signal but the 50-dma near $88.40 and the $90.00 level are both potential resistance. A new relative low under $79.50 could be used as a new bearish entry point.

Picked on July 26 at $ 82.87
Change since picked: - 0.95
Earnings Date 07/24/07 (confirmed)
Average Daily Volume = 1.8 million

Dropped Puts

MSCI Brazil iShares - EWZ - close: 64.28 chg: +2.10 stop: 64.15

The Brazilian market was up sharply with the main index up more than 2.6%. Shares of EWZ reacted and rose 3.3% toward resistance near $65.00. The iShares hit our stop loss at $64.15. You can see on the daily chart how the EWZ has broken out above potential technical resistance at the 10 and 50-dma.

Picked on August 06 at $ 59.90
Change since picked: + 4.38
Earnings Date 07/27/07 (unconfirmed)
Average Daily Volume = 9.7 million


FMC Tech. - FTI - cls: 94.07 change: +1.89 stop: 92.51

Oil-related stocks continued to rebound and FTI rose 2% on heavy volume, which is not good news for the bears. The stock actually gapped open higher at $92.92 before trading back down to $91.19. Unfortunately, our stop loss was at $92.51 so we would have been taken out at the open.

Picked on August 05 at $ 88.22
Change since picked: + 5.85
Earnings Date 07/30/07 (confirmed)
Average Daily Volume = 677 thousand


Harley Davidson - HOG - cls: 58.13 change: +1.51 stop: 60.26

We are going to abandon ship on HOG. The market's rebound looks too sharp and poised to continue tomorrow. Today's market strength lifted shares of HOG past short-term resistance at the $58.00 level. We'd rather cut our losses now.

Picked on July 23 at $ 57.75
Change since picked: + 0.38
Earnings Date 07/27/07 (unconfirmed)
Average Daily Volume = million


Lubrizol - LZ - cls: 56.53 change: -3.71 stop: 64.15

Target achieved. Negative analyst comments about LZ pushed the stock lower. Shares broke support near $60 and lost 6% plunging toward technical support at the 200-dma. Our target was the $57.00-55.00 range.

Picked on July 29 at $ 61.62
Change since picked: - 5.09
Earnings Date 07/27/07 (confirmed)
Average Daily Volume = 563 thousand

Dropped Strangles


Trader's Corner

More on Fibonacci Retracements

I wrote last week in this space (Wednesday, Trader's Corner; 8/1 OI Newsletter) on using fibonacci retracements to gauge possible downside objectives in a pullback and upside targets on a rally. Someone wrote me asking me questions on retracements as follows: "Could you give me some more information on why you say that common retracements are 38 50 or 62% and not some other figures? so whats special about these numbers? You also say something about sometimes 66%? That is question 1 and 2 is can I use the same system to figure how high for this rally?"


Those of you that know this, or don't much care, you can skip over it, but I was asked about how use of the sequence 38, 50 and 62 percent came about exactly and also my tendency to 'throw in' 66 percent (2/3rds) in the sequence, as its not part of the 'fibonacci' sequence).

Charles Dow made some early, maybe the first, observations about the tendency for stocks or the averages to retrace or give back anywhere from around a 1/3 to a half or slightly more of the distance covered by a prior advance or decline before the major trend resumes again. Dow talked a lot about the tendency for stocks or his averages to retrace around 50% of a prior move and then resume the major trend. Dow noted that retracements against the direction of the main trend up or down, were often about half of the prior price swing on a weekly closing basis.

There were further refinements on the theory of how much ground retracements will typically cover made by WD Gann, a famous and very successful stock and commodities speculator of the early to mid 1900s. Gann found it significant to use charts that had retracements noted between a major low to high or, high to low, of 1/4, 1/2 and 3/4ths; i.e., 25, 50 and 75%. Gann also found significance in the 1/3 and 2/3rd retracement levels.

The origins of one of the most popular "RETRACEMENT" theories for stocks and other markets came from someone who lived in the middle ages and was studying the population growth of rabbits. Yes, rabbits! Leonardo Fibonacci was an Italian mathematician who was doing such work in the early 1200's. The number sequence that is named after Mr. Fibonacci is where each successive number is the sum of the two previous numbers; i.e., 1, 2, 3, 5, 8, 13, 21, 34, 55, 144, etc. He found that rabbits multiplied in this fashion; i.e., 1 (well, we have to get her pregnant) bunny to 2, then to 3, 5, 8, 13 and so on. Assuming they got enough food and space, rabbits are going to multiply like gangbusters to a huge number over time. Ask an Australian if you don't believe it! Any given number is 1.618 times the preceding number (approximately) and .618 times the following number.

The Fibonacci number sequence later was seen to apply to how prices increased and decreased. There are technical indicators whose formulas rely on this number sequence, but the main application is to use the "fibonacci retracements" of .382 or 38%, .50 or 50% and .618 or, rounded off, 62%. The number 5 is in the Fibonacci sequence, and the others are ratios; .618 comes from the percent that each number is of the next higher number and .382 is the inverse of .618 (100 61.8 = 38.2). Well stick to the shorthand and round off to 38 and 62 percent as the important fibonacci retracements, beside 50%.

What I find most useful in trading is to track what would constitute the 38, 50 and 62% retracement points of counter-trend moves against the dominant trend that has come before. Use of these retracements is a very common practice and a quite popular point of reference among traders.
There is a simple pragmatic reason for this popularity and that is that buying or selling in these retracement areas often results in coming close to buying at the low and selling at the top of a move. Maybe the saying of buy low, sell high owes something to the common retracements as are highlighted in the chart below. There is the one other wrinkle.

However, like Gann, I find that the 2/3rds (66%) retracement is sometimes quite significant and is just a little bit more than the fibonacci 62% retracement level. When a stock or index is near to retracing 62 percent of the prior advance or decline, I also add the retracement line that shows me the 66 percent retracement. Sometimes a retracement stops right at 2/3rds of the prior price swing, as was the case with the lead S&P 500 (SPX) index on this recent sharp sell off:

In the case of the downside retracement of the March to July advance, to date anyway, SPX retraced exactly 66% of that run up and then rebounded sharply this week, resuming its prior dominant (up) trend. I couldn't have a better recent example of an exact fibonacci retracement.

You can set most charting applications to calculate retracements ranging from 25% to 38% (.38), 50%, 62% (.62), or a little beyond at 66% (2/3rds) or even 75% - usually, by pointing first at the low, then the high (pullback retracements) or first at the high, then the low for retracement rallies relative to a previous downtrend.


Another aspect of how retracements tend to go, is that when the first of the fibonacci retracement levels, 38%, is pierced, its common for the next retracement level, 50%, to be a next target for the decline in a downside retracement or for a rebound in an upside retracement. 62-66% is the next retracement target, up or down.

With downside (or upside) retracements that EXCEED 62 to 66% of the prior advance, the next 'retracement' to consider is one that retraces 100 percent of the prior move; e.g., in a downside retracement, a 'round trip' back to the last significant low (and where double bottoms sometimes set up).

Sometimes retracements tend to RESIST going to the next retracement level. Using the example of the recent downside retracements in the major indexes, in the Dow there was one Close below the 38 percent retracement, but not by much, followed by the next day's close back above this first retracement, with a repetition of this pattern again. This pattern suggests a still-strong up trend.

An index or stock that only sees a 'minimal' 38 percent retracement or a relatively shallow correction, is demonstrating still-substantial buying interest on the pullback. In the example of the Dow (INDU), sellers were not dumping the 30 Dow stocks beyond a certain point and buyers were there to bid on the stocks on dips.

To show the better relative strength in INDU, not only did the Average not fall nearly as far on a percentage basis as the much broader S&P 500, but today's Close was above near resistance implied by its 21-day moving average. I'll look at the upside retracement level targets and potential resistance further on.

A similar 'strong' or resistance to more than a 'minimal' decline in fibonacci terms, was seen in the Nasdaq 100 (NDX), with just one close below its 38% retracement level, but no others and followed by a strong 3-day rally this week; but not a close yet above its 21-day moving average. Stay tuned on that!

Sometimes of course, the retracements fall through the first 1-2 fibonacci levels but reverse before reaching the NEXT fib retracement. Such targets are about possibilities. Reversals happen all the time shy of a particular next retracement. These levels do give us some basis to assess downside or upside possibilities however.

You'll notice in the Nasdaq Composite (COMP) chart below, I've taken out what was the 38% retracement level. Once that first fibonacci retracement level was exceeded, I no longer had much interest in seeing it on my chart. Prices knifed through the 38, then the 50% retracements, then seemed headed to the next fib line at 2480 in COMP, a 62 percent retracement of the March-July advance.

Well, in the 2500 area, a 'natural even-100 level support/potential support, prices stabilized and reversed back to the upside. Would I be sitting around waiting for 2480 to be reached if in Nasdaq puts or short key Nas stocks? Of course no: COMP got close to reaching this sometimes 'final' retracement, the index was getting oversold on the 13-day RSI and the hourly chart showed a V-bottom (not shown) pattern. As I say often, you have to look at everything and have as few pre-conceived notions that fit 'ideal' patterns as possible. Hard to do sometimes!


Part of the question I was going to answer related to gauging the further upside potential ahead for this recent rebound by using fibonacci retracements. I advise traders to plot these levels, especially when price swings are getting volatile, which was certainly seen today.

It's easy to get sidetracked on possible price objectives when the market is making such wide-swinging moves. After a first big waterfall type decline, I also want to keep in mind the possibility that the major indexes could retrace 50 or 62-66 percent of their first major decline and then resume falling. Putting the fib retracement lines up on at least one chart of each major index is a great visual tool or aid for me in keeping perspective, such as for not getting bullish again too soon.

The major indexes could of course retrace more than 62-66 percent of the recent decline and then continue to rally. In which case I anticipate decent potential for a 100 percent retracement back to recent highs; if so, I'd want to watch for the potential for a double top.

To calculate the upside retracements, this time I'll start with the top as the 'anchor' and then drag and drop the fibonacci tool down to the recent low. The UPSIDE fibonacci retracements of the recent decline are shown below for the same indexes as seen above and I'll use their hourly charts for this purpose:


Upside objectives and potential resistance areas suggested by the 62 and 66 percent retracement levels come at 1506 to 1512. A daily close above 1512, not reversed (back to the downside) the next day would suggest potential for SPX to eventually climb back to the area of its recent high.


Key upside objectives and potential resistance points are noted at the red down arrows in my last two charts.



Please send any technical and Index-related questions for my answer or feedback to Click here to email Leigh Stevens support@optioninvestor.com with my name ('Leigh Stevens') in the Subject line.

Today's Newsletter Notes: Market Wrap by Keene H. Little, Trader's Corner by Leigh Stevens, and all other plays and content by the Option Investor staff.


Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.

Readers are urged to consult with their own independent financial advisors with respect to any investment. All information contained in this report and website should be independently verified.

To ensure you continue to receive email from Option Investor please add "support@optioninvestor.com"

Option Investor Inc
PO Box 630350
Littleton, CO 80163

E-Mail Format Newsletter Archives