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Trader's Corner

Computing Current Upside Possibilities

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It seems my 'regular' Wednesday Trader's Corner article has been slipping to Thursday the last couple of weeks. Last week (1/24/08) I wrote about the technical reasons that I thought the market had reached a bottom on the 23rd. This was my conclusion based on how the Dow 30 (INDU) held its long-term weekly support trendline, at least on a closing basis (the only way Charles Dow ever looked at it), and especially based on the long-term Nasdaq 100 (NDX) weekly chart; NDX had led the market up in recent weeks and months and if a major index was going to rebound from its major up trendline, it had to be NDX and that's what happened, so far at least.

The other reason I thought there had been a substantial upside reversal was another technical pattern, that of a key upside reversal, which was especially apparent in the S&P indexes. I don't need to go into all this again. If you want to look at or review my prior article you can click here if online or go back to your 1/24 OI Daily.

Assuming we have good reasons technically at least, to think that the market has found bottom, we've bought calls, sold puts or done some other bullish strategies in indexes or stocks. What is then going to be our first, second and third upside objectives? Watching the market and seeing how it 'looks' from day to day? A lot of traders do this and some or many lose money because they don't have a game plan and end up reacting to the market rather than to the market AND to reasonable expectations.

I'll demonstrate a tried and true method of setting some upside objectives or expectations. These are not always going to be right of course but it is a good way to gauge potential targets on a recovery rally. The other part of your trade plan is determining your risk or exit point if the trade goes against you, which is another story but as or more important.

MY FIRST OBJECTIVE:
Because the major market indexes had exceeded their prior major summer lows, I took the prior August lows as my initial or FIRST objective, which I also figured would be an initial key resistance. This idea is based on the idea that 'prior support (a bottom), once penetrated, 'becomes' resistance later on'. A prior low like this is both a first upside target and a first key resistance.

At or approaching a prior major low, there were many traders and investors who did some buying and once the upside reversal was seen then 'chased' prices up from there. This price area for many is their 'cry uncle' point weeks or months later on where they will exit if the benchmark indexes don't find support again in the same area.

There are many more holders of stock that did not exit when prices fell through this prior support. Some if not many are wishing that they could at least get out in this area if prices rebound to it. The market outlook has soured with high bearish sentiment so there are many just looking to sell a rally and the prior 'floor' becomes one target of selling. This is how a floor 'becomes' a ceiling.

In the example below provided by the S&P 500 (SPX) chart, the first level of resistance I had noted as key to overcome to suggest a next, higher, upside target was 1370, at the August intraday low which got exceeded today on the Close. Obviously, the August-October (and for the most part in December) closing lows were more in the 1400 area, so this is another overhanging resistance and probably the most potent. Today's close at the 21-day moving average is another potential near SPX resistance (and target).

The Nasdaq 100 (NDX), another key index to watch for the reasons noted initially, also of course cleared its prior 1805 low on the close and by a comfortable margin. Another resistance and potential next upside target is for a move up to the 21-day average.

The series of potential upside objectives and potential resistance levels implied by the so-called 'fibonacci' retracements are what I want to touch on next.

FIBONACCI RETRACEMENTS:
I'll explain what the fibonacci retracements of a prior move ARE, after showing these levels on the same two (SPX and NDX) daily charts. Those who want to review or need an explanation of the hows and wherefores of fibonacci (fib) levels can jump to this last section and peruse it.

There first is a question of whether we measure the 'fib' lines from the recent lows to the highs of December or the retracement amounts of the SECOND LEG down only, OR the entire decline from the late-October peak to the recent low. The answer I apply is to measure the fibonacci retracements of the last LEG down. In a bear market environment like the one I believe we'll be in for awhile, I wouldn't expect much more than a 'minimal' retracement which would be either, 38% (already done) a 50%, possibly a 62% retracement, of the last major downswing. These last two retracement levels are the ones I take as my next potential upside objectives (and resistance levels).

Repeating a different view of the SPX daily chart below, you may wonder if the retracements from the 1270 low should be measured to the 1523 high or the 1499 high that came later. Since a typical intermediate to major decline (or down leg) will have two parts or segments, I begin at the top of the first segment, which would imply measuring the 38, 50 and 62 percent upside retracements of the 1523 to 1270 decline.

I didn't mention the 38 percent fibonacci retracement level as it has already been reached and falls in the same area of resistance as implied by the prior 1370 low. The 50% retracement level intersects in the 1400 area discussed already as resistance measured by a different means. These things fall in clusters sometimes. 1426 is a possible third upside target and potential resistance implied by the fibonacci 62% retracement; slippage to a little bit more than 62% is seen at the 66% (2/3rds) retracement, which is also often a key resistance, but not a fibonacci level.

The next chart is again one we've seen of the Nas 100 (NDX), but one next just focusing on the fib lines. Here, the second, third and forth upside targets/resistance points on a rebound (beyond a recovery to the prior low), that could be hit and would also be potential resistance areas, are highlighted at NDX 1868, 1922 and 1976.

FIBONACCI:
The origins of one of the most useful retracement theories for stocks, stock indexes 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, for a gain of 10. 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)
2. If the demand was average, you could hope to buy the stock at 15, which is a give-back of .5 or one-half of the 10 point run-up.
3. If demand turned out to be weak on the way back down from the high point of $20 (e.g., after some news stories about the company die down or change), you might anticipate or wait to see if you could buy the stock at 13.75 (.62 of 10, subtracted from the high point 20).

Also useful in trading index and stock options, is to track what would constitute the 38, 50 and 62% retracements, after a minor, intermediate or major 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), to see what would be the retracement levels in a recovery rally, use of the retracement "tool" is by first pointing at the high, then the low.

The reverse of this method is used within an uptrend, where prices begin a counter-trend decline: first point at the low, then at the high to see what the retracements levels could be of the prior advance.

SOME GENERAL GUIDELINES ON FIBONACCI RETRACEMENTS:

A strong trend will usually see only a 'minimum' price retracement -- around 1/3 to 38%. If prices start to hold around this area, trade entry may be warranted.

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 done from the low to the high, high to the low, of the trading period being looked at; e.g., hourly, daily, weekly charts. If daily, measure from intraday high to intraday low; not usually based on the highest close to the lowest close, but this is another method also. I use retracements based on closing levels some and this way can show sometimes where prices might be headed.

QUESTIONS/COMMENTS:
Please e-mail Click here to email Leigh Stevens support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

GOOD TRADING SUCCESS!
 

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