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Resistance at Breakdown Points and Fib Retracements

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Resistance at Breakdown points and Fib Retracements

OIN SUBSCRIBER QUESTION:
"...were there technical resistance areas that were hit at recent highs and what were they?"

RESPONSE:
There were a couple of types of resistance that got hit by key major indexes recently. ONE aspect of resistance is a rally that returns to an area of prior support. We could say that prior support once broken can 'become' resistance later on. This is the meaning of 'supply' or a supply overhand. I'll show a couple of examples on the charts.

If there is a support area that is perceived by many or most market participants, and that support gets pierced, there are a lot of market players that don't get out of all the stock that they might like to; especially institutional fund managers. They won't sell all the stock they want to (to raise cash) on a break of support as the prices of their stocks will go down too much if they just dump. Many times when a key index or average, such as the Dow or S&P, etc. comes BACK to that prior 'breakdown' point, there is considerable supple of stock that becomes for sale. This is the concept of a resistance at a prior BREAKDOWN point.

A SECOND aspect of resistance is what often develops after certain RETRACEMENTS, as measured as a rally or pullback measured as PERCENTAGES of a prior price swing. I'll show recent examples of some of these retracements, but first give an introduction to retracement theory.

Charles Dow made some early, maybe the first observations about the tendency for a stock or the overall market to retrace or give back anywhere from around 1/3 to 1/2 of the distance covered by a prior advance or decline, before the major trend resumes again. It was very common Dow noted, that retracements against the direction
of the main trend were often about half (50%)of the prior price swing.

There were further refinements on the theory of how much ground retracements will typically cover made by W.D. Gann, a famous stock and commodities speculator of the first half of the 1900s primarily, Gann found it significant to use charts that had retracements noted between a major low to high or high to low of 1/3 to 2/3rds of a prior price swing.

The origins of one of the major 'retracement' theory for stocks and other markets came from someone who lived in the middle ages and was studying the population growth of rabbits. Yep, Wabbits! 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.

The technical indicators whose formulas rely on this Fibonacci number sequence, but the main application is to use the "fibonacci retracements" of .382 or 38%, .50 or 50% and .618 or 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% 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, after a minor or intermediate price. 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. Maybe the saying of buy low, sell high owes something to the common retracements.

MEASURING FROM INTRADAY HIGH TO INTRADAY LOW VERSUS FROM A CLOSING HIGH TO A CLOSING LOW
This difference in these two ways of measuring retracements can be significant as I'll show. It's good to look at retracements of a prior decline or a prior rally on both a bar chart showing the High-Low-Close (HLC) versus a close-only Line chart.

The recent upside retracement of the May-July decline in the S&P 100 (OEX) equaled a bit more than 50%, but that was only seen on one intraday 'spike' high as seen in the OEX daily bar chart below. Also of interest here is that recent rally high, on an INTRADAY basis was back to the prior 'breakdown' point dating back to the March-April period. One that area, around 608-609 in OEX was pierced in June, there was another down leg that followed.

You can set most 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% - often, 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.

In a countertrend rally within a dominant downtrend - once a minor downside correction begins look to see if a recent high represented a 38, 50, or 62% retracement of that high relative to the rally starting point. If the (up) swing high also failed at or under a key down trendline and was accompanied by an overbought condition, its a sure tip off to short the stock or play puts in the case in stocks or indices.

The strongest market segment has been in tech stocks and the strongest of the strong, in terms of the Nasdaq indices, has been the Nasdaq 100 (NDX). NDX recently rallied to and a bit beyond the 2/3rds or 66% retracement level. Given that there were two consecutive days where the Index closed above the 66% retracement level, it looked like NDX was going to go on and retest its summer highs, WITHOUT having a correction first.

HOWEVER, given that there was this 2/3rds retracement seen above and given that the market was getting overbought, the correction that followed wasn't surprising. By taking a look at the retracement levels on a LINE chart below, a more clear cut resistance is seen in terms of the 62 and 66% retracdment levels.

On a pullback or a retracement of a prior advance where the a correction "resists" dropping back even 38%, after a strong up move, I may add a 25% retracement line. If a deep correction falls below the 62% or 66% retracement, I may add a 75% retracement line, but this is quite rare in the case of stock indexes; it's more common in individual stocks.

If the correction of a prior rally goes above 66% retracement, I assume that the correction will a full 100% or a "round trip" back to the origin or starting point for the decline.

Again, it's useful to measure retracements both by use of a bar (or candlestick) start and look at the intraday high to intraday low or vice-versa in an advance, AND also to have a chart set up that uses a close-only line chart. Charles Dow, who I mentioned, used to ONLY consider CLOSING levels as being of 'true' significance. Candlestick charting describes the intraday day low or high as the "shadow".

A strong stock or strongly trending index will tend to have retracements that EXCEED the 50% level. A weak stock or weak/lagging index will tend toward retracements that are LESS THAN 50%, which is seen with the Dow 30 (INDU) below. The recent Closing high in INDU also reached a prior 'breakdown' point, where we can assume that there was more than average supply or selling interest.

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, 'little bit' more, which would be 62%; a bit less than 50% in the case of a weaker stock or index like the Dow would be a 38% retracement.

If prices climbed to the 62% retracement level, in an overall downtrend, such price action tends to suggest a favorable exit if long a stock or in index calls, and favorable trade entry to short or buy puts. In terms of risk strategy after that, you can place a stop just over the retracement level.

Maybe shorting in the 62-66% retracement area will prove to be a profitable trade in NDX (more than seen so far), although I'm not counting out the ability of the Nas 100 index to challenge its prior high. In terms of trading STRATEGY if long calls, I myself don't like to hang in with a big option or stock position, hoping for that last rally potential before there's a major test of a major prior high!

SOME 'RULES OF THUMB' REGARDING 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 of around 1/3 to 38%. 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., a hurricane or an act of 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 often a retracement of 62% or even 2/3rds (66%). If prices don't' exceed this retracement area, its also a good target for initiating a trade that favors a resumption of the DOMINANT or major trend existing before the countertrend retracement type move began.

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 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, which is 100%.

5.) Retracements are commonly done from the low to high, high to low and not based on the highest close to the lowest close, etc. However, as I've discussed, also experiment with retracements based on closing levels as they also are worth exploring.

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

GOOD TRADING SUCCESS!

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

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