Option Investor
Trader's Corner

Anticipating, Not Reacting

Printer friendly version

Much as I try to get this column out on Wednesday, it keeps slipping to Thursday. Well, around or about mid-week I suppose is what I can say is when I get to this educational piece. At least I hope that this 'Corner' will illuminate useful aspects to trade entry and timing.

There are two subjects today I'll discuss relating to ways that technical analysis can tip us off to what is AHEAD in the economy or what are the likely limits of corrections. My two subjects:

1.) Dow Theory and the current (we're almost certain to be in) recession
2.) Fibonacci retracements

I read the following news report the other day:

"Alarm bells were set off Tuesday by a grim report on service businesses, which make up the majority of the U.S. economy. The Institute of Supply Management said that activity in the service sector declined for the first time in nearly five years. This report also indicated that employers are cutting staff. The survey covers the retail, transportation and health care industries as well as hard hit areas such as finance, real estate and construction.

Some economists argued that the normally low-profile ISM services reading, coupled with the government's report Friday showing the first monthly net loss in jobs in more than four years, is proof that recession is now a reality.

'My forecast had been that the recession would begin this quarter, but the hard data wasn't there yet,' said Keith Hembre, chief economist of First American Funds. 'But now we're seeing that. The service sector is a much larger component of the economy [than manufacturing] and this is very much a recession reading.'

The National Bureau of Economic Research is the official arbiter of whether the economy has entered recession. But the NBER typically does not declare a recession until well after one has begun."

This is similar to what I say over and over to option traders. Anticipate, anticipate, anticipate. Anticipate tops and bottoms. Anticipate trends before or as they are developing, not AFTER those trends are apparent to everyone. As we all know, the internet and computer pioneers made the big bucks by anticipating new trends.

We have in the weekly/monthly price action of the Dow 30 Industrial (INDU) Average relative to the Dow Transportation Average (TRAN), a forecasting tool that predicted a major economic downturn some weeks back. The action of TRAN gave clues to coming economic weakness MONTHS back.

By the prediction rules for the economy and stocks, as laid out by Charles Dow and known broadly as 'Dow Theory', we could have gotten a
'confirming signal' on where this economy was headed (down!) back during the weeks ending 11/9 and 11/23/07 when a Dow Theory market 'sell signal' was confirmed.

The recovery rally in INDU after this sell signal carried up to the 13500 area and this period would have given even the slowest institutional money manager time to raise some cash and thereby improve his or her current performance.


I wrote about this topic in my Trader's Corner last week and updated my view on it in my most recent "Index Trader" column. My view being that I didn't assess the upside prospects for the recent rebound as much greater than the last week's closing levels. That the lion's share of the recovery gains had probably already been seen coming into this week. My reasoning and experience over three decades of trading suggests that rallies counter to the dominant trend (now down) won't typically carry more than a minimal 'Fibonacci' 38% to 50% retracement of the last price swing in the major stock market indexes.

What the Fibonacci retracement levels ARE and how they get used is at the END of this column for someone who wants to review this material and out of the way for someone who doesn't.

If you didn't see my last (Index Trader) article on my most recent update on the Fibonacci trade objectives (Sat, 2/2), you can click here if you want to review it.

Now that the market got slammed this week, I'll briefly review how the recovery rallies in the major indexes fared relative to the Fibonacci retracement levels for the S&P, Dow and the Composite and the results are amazing. Applying Fibonacci retracement levels to your charts can be an amazing tool for YOU to use. Traders use retracement objectives widely. Investors would probably benefit more from knowledge of Dow Theory to suggest the periods where it could be opportune to raise cash (or put cash to work).

A question in using the fibonacci retracement line tool in widespread use in charting applications is whether to measure the 'fib' lines from the highs of December (the retracement amounts for the second 'leg' down only) to the recent lows, OR the entire decline from the late-October peak to the recent low.

In this recent decline, I measured the fibonacci retracement levels for the last LEG down; i.e., starting at the December high and then (next) selecting the lowest intraday low (on 1/23) seen before the first rebound. The retracement charting tool will fill in the fibonacci retracement levels in between. The retracement percentages will be either pre-set or you can specify the ones just you want to see. If a rally has already gone beyond the 38% level, as was the case recently in the S&P and Dow, you can strike that one so as to not clutter up your charts.

The Fibonacci retracements are 38, 50 and 62 percent. We can say that a 100 percent retracement, or back to the start of the last price swing, is in the Fibonacci series also; retracements all the way back to a high or low, that hold those levels, are how double tops and bottoms come about.

In a bear market environment like the one we're in, don't generally expect more than a minimal retracement rally: either 38% in weaker stocks and indexes, or around 50% in the strongest stocks and most oversold indexes. This is not to say that the index or stock in question will necessarily go to a lower low as seen in the SPX, INDU and NDX daily charts below, but that the upside potential, especially on the first rally, is limited, often to retracing one-half of that distance or less; e.g., 38%.



I find the fib retracements to be a great aid in setting stop or exit points on some trades. For example, if I thought it unlikely that the Dow would climb much beyond a level equal to a one-half (to 12706) retracement of its last decline, I could buy DJX puts at 127 and set my exiting stop a few percentage points above that line; e.g., at 128.0.

In a retracement of a prior downswing, if prices climb much above one of the 3 Fibonacci retracement levels, an index or stock has some potential to go to the NEXT fib retracement level. No reason to risk more a little to see if you're right. (An explanation of some common retracement pattern is at bottom.)


How the strong becomes the weak. The Nas 100 led the August-October advance, but has been the weakest index on the second leg down. By the way, the second leg down in a decline is often at least a fibonacci 1.62 times the first decline. In the case of NDX, that's a close approximation as the second leg down (2147 to 1693) was 1.75 times greater than the first down leg (from 2239 to 1980).

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.


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.

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


Trader's Corner Archives