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Like many, I have often tried and failed at interrupting such points, resulting in buying tops and selling bottoms. Think its, "The Fear Factor" working at its best?
But the origins of one of the most useful retracement theories for stocks and other markets came from someone who lived in the middle ages and was studying the population growth of rabbits.
Leonardo Fibonacci was an Italian mathematician who was doing such work in the early 1200s. The number sequence that is named after 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. Any given number is 1.618 times the preceding number and .618 times the following number.
There are some technical indicators whose formulas rely on the Fibonacci number sequence, but the main application is to look at price moves in stocks or index and use the fibonacci retracements of .382 or 38 percent, .50 or 50 percent and .618 or 62%.
Looking at the number progression of 1, 2, 3, 5, 8, 13, 21, etc. where each succeeding number is the sum of the two before it, there are certain arithmetic relationships that exist: .618 is the percent that each number is OF the next higher number; .382 is the inverse of .618 (100 61.8 = 38.2). Well stick to a shorthand and round off .382 and .618 to an even 38 and 62 percent %.
Imagine a stock that in 12 months goes from 10 to 20, up $10 dollars. The stock has had a fantastic double but you think it could go yet substantially higher. You wished you had owned it at 10 and but still would like to buy it, but cheaper than 20. The stock starts to trade lower. At what level could you hope to buy the stock?
Considering what would constitute the 38, 50 and 62% retracements of the 10 to 20 dollar advance would suggest the following -
1. If the demand is really strong for the stock, you might not be able to buy it cheaper than 16.25 (.38 of the 10 gain subtracted from the 20 high point)
Also useful in trading index and, stock options, is to track what would constitute the 38, 50 and 62% retracements, after a minor or intermediate price swing.
There is a simple pragmatic reason for this popularity; buying or selling in these retracement areas often results in coming close to buying at the low and selling at the top. Maybe the saying of buy low, sell high, owes something to the common retracements.
You can set most charting applications to calculate retracements ranging from .33 to .38, .50, .62 to .66, In an correction (fall in price) within a larger uptrend, use of the retracement "tool" is by first pointing at the low, then the high. An example is provided below with the most recent (daily) chart shown below for the S&P 100 (OEX) and using my charting programs retracement drawing tool.
It is interesting to note that the OEX that as of the chart date below, the index has now come within 1 point of a 50% retracement of its October to early-March advance. Stay tuned on what follows! Many traders will assume support in this area because of the Index having retraced now fully half of its prior run up.
As, well, this one-half (.5) retracement coincides with current price as being at its prior low, at its 200-day moving average and near my lower (moving average) envelope line. All suggest a possible rally point, technically. Talk about convergence!
Considering just the Fibonacci aspects; if 554 is pierced then 546.50, at the 62% retracement, is where a final bottom might be (according to the common retracement concept). This view assumes that the OEX is still in an uptrend and won't retreat all the way back to the prior (late-Oct bottom) low.
By the way, you can always use a calculator and add or subtract the 3 percentage figures once it appears that a high and a low is in place for any minor or secondary trend in an index or a stock, and which allows a calculation of the retracement possibilities.
COMPUTING CORRECTIONS WITHIN AN UPTREND -
WITHIN A DOWNTREND -
In general in a countertrend rally within a dominant downtrend, once a minor downside correction begins, look to see if a rally gets to as high as a 38, 50, or 62% retracement of the prior move from high to low. If the rally begins faltering and buying interest dries up, it adds to the possibility that prices have rebounded as far back up as they are going to. And, to the more venturesome suggests a possible short or a play in puts.
SOME GENERAL GUIDELINES ON FIBONACCI RETRACEMENTS:
In a normal trend (not powered by something extraordinary), a retracement will often be about half or 50% of the prior move. A common level to buy or sell by some will be at this point. After about this much of a return move has occurred; with an exit if it continues on much beyond 50%; e.g., 5% more.
Within the range of normal, but evidence of a weaker trend, will be a retracement of 62% or perhaps 2/3rds (66%). If prices hold this area, it can suggest initiating a trade, with an exit if the retracement exceeds 66%.
If a retracement exceeds one level, look for it to go to the next; e.g., if a retracement goes beyond 38%, look for it to go on and approach 50%. If it exceeds 50%, look for 62%. If a retracement exceeds 62% (or a maximum of 66%), then I look for what I call a "round trip" or a return all to the way to the area of the prior low or high this type action suggests a retest of the low or high and is the ultimate "retracement" so to speak, of 100%.
Retracements are most commonly done from the low to the high of the trading period being looked at (e.g., hourly, daily, weekly charts). If daily, intraDAY high to intraday low, and not based on the highest close to the lowest close, etc. However, you can experiment with retracements based on closing levels as they also are worth exploring; and can add to understanding of where the market is going. The common retracement levels work on all time frames or chart types; e.g., hourly (or less), daily, weekly and monthly charts.
Good Trading Success!!