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The Best Fit

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Perfectly fitted suits or dresses boost confidence, giving wearers the sense that they're people who are going places. A perfectly fitted Fibonacci bracket can do the same, giving traders the sense of where prices might be headed. They help set targets.

For those unfamiliar with Fibonacci numbers, here's a recap from my Saturday, May 14 TradersCorner article. The term refers to the series of numbers (1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144 . . . .). After the first two numbers, each new number in the series is calculated by adding the previous two numbers. As my previous summary noted, this series of numbers predicts everything from the number of rabbits born to a single pair n months after they begin breeding to the number of petals on a flower. Flowers tend to have 3, 5, 8, 13, 21, 34, etc. petals.

After the first five numbers of the series, the ratio of one number to the next in the series is 0.618, making each number 61.8 percent of the number that will follow it. This number and proportions of this number turn out to have relationships to all kinds of thing, too, including movements of the financial markets. After a rally or decline, prices sometimes reverse and retrace part of the prior movement before resuming the rally or decline. Often those retracements stop at Fib numbers or the ratios between the numbers. For example, a 61.8 percent retracement is sometimes seen.

Annotated 30-Minute Chart of CSCO:

Newbie traders might conclude that there's nothing more to the relationship of Fib numbers to prices than self-fulfilling market action. That would happen if all participants lean toward selling or buying at a well-known Fib number just because they're . . . well, well-known as potential support or resistance. However, as that previous summary noted, that wouldn't go far in explaining the relationship of Fib numbers to flower petals. Something more might be at work.

Most charting services make it easy to determine where Fib levels might come into play. Most include a tool that allows a bracket to be snapped onto the chart.

Annotated 30-Minute Chart of CSCO:

After a rally or move completes, the Fib bracket can be used to predetermine where support or resistance might lie during a reversal. Take another look at that second chart, however, and imagine extending the 38.2% retracement to the left. It's easy to see that historical support/resistance had already existed in that $17.95 area. Frequently, after a strong move has finished and a Fib bracket is snapped on the entire move, those Fib levels will hit points at which the rally or decline had temporarily stalled, producing levels of historical support or resistance. That observation can be used to extrapolate the point at which a move might end.

Fitting a dress or suit requires tailoring it to shoulders, waist and hips. Until the waist and hips fit right, the garment shouldn't be hemmed because the hem might be too short or long. Fitting a Fibonacci bracket to determine where the move might end requires a little tailoring, too.

Annotated Daily Chart of the RLX:

Although my fitting of a Fib bracket on July 21 was a few points shy of the actual high hit on July 29, it did predict, more than a week before the actual high was hit, that the rally might be topping out. It's apparent from the RLX's chart that it would have been possible to hit the top target more precisely if the bracket had been fitted with the 50 percent level closer to 440, snugged under those candle bodies in early June rather than at the top of May's candle shadows and the bottom of early June's.

Annotated Daily Chart of the RLX:

Fitting a Fib bracket to extrapolate a target requires some judgment and discretion. On July 21, when I was trying to find an upside target, I thought the fit displayed in the first chart was the better fit, but the second version turned out to be the correct one.

Such a fitting of a Fib bracket would have warned bulls to protect their profits, although it would not have been enough evidence to suggest new bearish entries. Setting such a target does allow bears to begin watching for a reversal. Such was the case with the Russell 2000 this summer.

Annotated Daily Chart of the Russell 2000:

Signs of a reversal in the making did not take long to appear and included a breaking below the ascending trendline off the May low.

Fitting a Fib bracket to extrapolate a possible upside or downside target can be as much art as science, but still proves helpful. Make the fit as close as possible around the midsection and the hem should fall right, too.
 

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