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More on Fibonacci Retracements

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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?"

HISTORY OF RABBITS AND MARKETS

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.

OTHER RETRACEMENT ASPECTS

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!

NEXT: UPSIDE RALLY POTENTIAL IN FIBONACCI RETRACEMENT TERMS

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:

THE S&P 500 (SPX) HOURLY CHART WITH FIBONACCI RETRACEMENT LEVELS

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.

THE DOW 30 (INDU) HOURLY CHART WITH FIBONACCI RETRACEMENT LEVELS

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

THE NASDAQ COMPOSITE (COMP) HOURLY CHART WITH FIBONACCI RETRACEMENT LEVELS


GOOD TRADING SUCCESS!

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