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More on retracements as a guide for trade entry

HAVING TROUBLE PRINTING?
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OIN SUBSCRIBER QUESTION:
It looks like today's rally is the break out above trendlines that you indicated as confirming a recent market bottom. That the indexes had fallen some significant amount already and unlikely to drop more. I'd like to understand more about retracements and what makes them significant. What else might have been bullish at the last low, enough to give a good reason to buy index calls?

RESPONSE:
I wasn't convinced that a rally would pierce technical resistance until, as you say, today's rally broke out about some key down trendlines. If I think there's a bottom in place, I prefer buying index calls BEFORE there is a "confirming" breakout, making calls cheaper of course. Hey, wouldn't we all!? Not necessarily. Not everyone has the confidence in technical analysis, preferring to wait until a new trend emerges. Nothing wrong with this way to trade, but its not what I prefer.

The recent market low was characterized by these technical considerations:

1. A key retracement of a prior move, up or down.
In the recent case, it was that a "maximum" downside retracement had been reached for a decline IF the market was still in an uptrend. My assumption was that the market was still in an uptrend. Its helpful if there is then a period where there is not a lower low or not by much, and that prices rebound from those lows. This is building a support "base".

2. High bearish sentiment suggests a bottom, high bullish sentiment, a top. I look for at least ONE day where my call to put indicator is at an extreme; this is a "leading" indicator and such extremes most often occur 1-5 days before a bottom or top. The S&P low to date (for the current move) occurred on the 3rd trading day after heavy equities put volume, relative to calls, giving a contrary suggestion that a bottom was close at had.

3. Look for an oversold or overbought extreme to also suggest that the trend could reverse.

4. A low or high touches an extreme suggested by a 21-day moving average envelope line. One set at a percentage (e.g., 3%) that tends to "contain" most trading in the indexes.

5. If average (10-day) volume is rising, while prices are bottoming or going sideways for a time, this is a plus, showing accumulation of stock.

A sixth factor so to speak is a CONVERGENCE of patterns or indicators. Having made a key retracement by itself is not usually enough to suggest the market is set to reverse. Traders showing a very bearish outlook on some particular day is not enough in isolation. However, these elements coupled with an oversold reading in an indicator like the RSI or Stochastics and coupled with a retreat to my lower envelope line can be quite significant.

In the S&P 100 (OEX) chart below, the most recent up trend is measured from a beginning at the blue up arrow and ends at the blue down arrow. Here, only the "maximum" (for an uptrend) 62 and 66% retracements are seen at the blue dashed level lines.

The last low has a yellow circle and is where both the 2/3rds retracement is completed, but also where my lower envelope line is touched. What determined that this lower line was 2.5% under the 21-day moving average. The envelope lines that contain most of the trading in the S&P indexes ranges from 2.5 to 3% usually. The low prior to the most recent bottom was 2.5% and I assumed that the next low would be the same and it was. Simple in this case.

The second indicator, shown above, that of the 13 (a Fibonacci number as will be discussed below) day RSI or Relative Strength Index, shows that an oversold extreme here occurred in the same time frame as OEX reaching its 66% retracement; AND, just after the bearish "sentiment" extreme seen at the bottom of the chart above.

If you had trusted (not always to do!) these confluences of technical aspects pointing to a possible bottom, buying calls at the 66% retracement has turned out to be a quite profitable trade.

RETRACEMENTS
Dow, Charles Dow, (as in "Bond, James Bond") made some early, observations about the tendency for a stock or stock index to retrace or give back anywhere from around 1/3 to 2/3rds of the distance covered by a prior advance or decline, before the major trend resumes again. The most common such retracements that were against the direction of the main trend, were about half (50%)of the prior price swing.

The origins of a useful "retracement" theory came from someone who lived in the middle ages and was studying the population growth of rabbits. Yep, 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 (approximately) and .618 times
the following number.

A principle use that "fibonacci retracements" are put to is to measure countertrend retracements of prior price swings; of .382 or 38% (sometimes also 33%), .50 or 50%, and .618 or 62% (sometimes also 66%). 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% as the important Fibonacci retracements, beside 50%. Use of these retracements is a very common practice and a 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. "Buy low, sell high" may owe something to the common retracements where "low" refers to buying after a retracement of a third to half of a prior move.

The most recent low in the S&P 500 (SPX) was an exact 66%,
2/3rds, retracement.

The added indicator for SPX in this next chart and briefly described above, is the 10-day moving average of NYSE advancing volume. When it's rising, stock in general tends to be under accumulation and there is buying going on even on upticks which is what advancing volume represents; stock bought on a price tick higher than the preceding trade.

If the correction of an uptrend falls below a 66% retracement, I start to assume that the correction will be 100% or a "round trip" back to the origin or starting point for the rally. It also can be useful to also look at a close-only line chart as well as a bar or candlestick chart.

Such a deep retracement would be more commonly seen in a high beta or more volatile stock than would be seen in an index typically, at least on a daily chart. Retracements of this much are more common in the indices on hourly or other intraday
charts.

Just so you know that I am not just talking about downside retracements only, in a countertrend rally within a dominant downtrend (once a minor downside correction begins) look to see if a recent high represents or is CLOSE to a 38, 50, or 62% retracement as shown in the past chart of the Semiconductor Index (SOC) below.

If the (up) swing high also failed at or under a key down trendline or was a double top, etc. and was accompanied by an overbought condition, its a sure tip off to short the stock or play puts in the case of the indices.

To use retracements - what you need is some evidence that a price swing has run its course and that a counter-trend or move in the opposite is developing.

In a downtrend, the 38, 50 and 62 percentage figures are added to the most recent low, when it becomes likely or your hunch is that a minor counter-trend rally is underway; e.g., prices and volume surge. The expectation is that in a normal or typical market, prices will rebound an amount that is equal to about half of the last decline or, a little bit more, which would be 62% or a bit less than 50%; i.e., 38%.

SOME RULES OF THUMB ON RETRACEMENTS -

These guidelines mostly are related to the most common retracements, that of the fibonacci 38, 50 and 62% retracements. 1.) A strong trend will usually see only a "minimum" price retracement -- around 1/3 to 38% (sometimes only 25%). If prices start to hold around this minimal retracement area, this action may be suggesting trade entry as there may NOT be a deeper correction.

2.) A "normal" trend in stocks, indices, commodities, currencies or bonds that is one not powered by something way out of the ordinary (e.g., terrorism), will often see a retracement develop of about half or 50% of the prior move. The most common level to buy or sell is this retracement amount, with an exit if it continues on much beyond 50%; e.g., 5% more.

3.) Within the range of normal trend, there is SOMETIMES a retracement of 62% or even 2/3rds (66%). If prices hold this area, its also a good target for initiating positions in calls or puts with an exit if the retracement exceeds 66% -

4.) 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 begin to look for a "round trip" or a return all the way back to 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%.

5.) Retracements are most commonly done from the low to high, high to low and not based on the highest close to the lowest close, etc. However you can also experiment with retracements based on closing levels as they also are worth exploring as already noted above.

6.) The common retracement levels work on all time frames or chart types; e.g., hourly (or less), daily, weekly and monthly charts.

LAST BUT NOT LEAST -
In a strong trend, either up or down, the typical retracement will be shallow. From 2004 ...

In the retracement chart above, once the double bottom low was made in April-May, I went back to the original high to use in measuring retracement levels.

HOW TO APPLY RETRACEMENTS WITH A CHARTING APPLICATION
You can set most, if not all, 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 this done by by pointing first at the low, then the high (pullback retracements) or first at the high, then the low for retracement rallies in what you perceive to be an overall downtrend.

I used to chart by hand and then use my calculator, adding or subtracting the 3-5 percentage figures, once it appeared that a high and a low was in place for the trend in question. Ah, the good old days NOT!

Good Trading Success!

NOTE -
Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.
 

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