I hear a lot of debate these days about whether technical analysis works. Certainly, as markets marched higher after August's bearish price/RSI divergence, markets defied most predictions of most technical analysts. Should we throw out technical analysis?
There's no need to throw the baby out with the bathwater. Even when technical analysis doesn't work, it does.
I'll show you what I mean. In his May 14 Trader's Corner article, Leigh Stevens discussed Fibonacci retracements. Leigh pointed out that a normal retracement would be 61.8 percent of the previous move. As Leigh pointed out, the "number 5 is in the Fibonacci sequence," with .50 or 50 percent retracements often watched. It's been my experience that a 50 percent retracement often finds powerful support or resistance. Another important number on the default Fibonacci brackets provided by most chart programs is the 38.2 percent retracement.
Before we go to the charts, I want to offer my standard caution that I rough out my articles a week or two ahead of their publication. The charts will not show current prices.
On Friday, November 6, 2009, I happened to be watching a one-minute OEX chart with a Fibonacci bracket slapped on what had been the day's highs and lows.
Annotated One-Minute Chart of the OEX:
Notice how the first test of the 50 percent level saw prices knocked all the way back to the 38.2 percent level. They were similarly knocked back with the first test of the 61.8 percent level. However, the adherence to the Fib bracket began falling apart later, with a failure of the 38.2 percent support followed by prices suddenly running higher and gapping above the 50 percent level. Gapping prices above a key resistance level is one way that big money can force shorts to help them drive prices higher.
Annotated 1-Minute Chart of the OEX:
Was the failure of the 61.8 percent retracement level to turn back prices the rest of the day a failure of technical analysis? No. Instead, watching these Fib levels or other tools of technical analysis gives traders a way to determine that something has changed. In this case, I was watching because I wanted to guard profit on a profitable XEO iron butterfly that I intended to exit. I would have made more money if the XEO had turned down back toward the day's lows, where I had already exited part of the trade. I wanted to let a resistance test occur. The resistance appeared to be holding, but the Fib bracket alerted me that something was changing and I exited the rest of the position to locking in some profit, if not the profit I'd hoped to gain.
In addition to providing a way to measure when the markets might be behaving or not behaving as expected, technical analysis can help traders set profit stops, as I was doing, or stop losses. Fib brackets, in particular, can provide rational decision points when no others appear apparent. The nested Keltner bands I like to use can do the same. So can Bollinger bands. So do the formations we sometimes watch.
Annotated Daily Chart of the OEX:
As we now know, prices were to break above the right-shoulder level of this potential head-and-shoulders formation and zoom to a new recent high. Although the bearish warning of the head-and-shoulders formation was not to be realized, the break up through the right-shoulder level did effectively warn bears to step aside. That's useful information.
Looking along the ridged back of the rising and falling prices since August, we can pinpoint several failed-to-fulfill potential head-and-shoulders formations. Each push above a right-shoulder level and failure to confirm the formation showed traders that bullish momentum was still stronger than bearish momentum. Those breaks alerted bears to step aside. The presence of those formations and the ongoing price/RSI divergences fail to deliver the promised result only because we technical traders believe too strongly that they're offering promises. They're not.
What they offer is opportunities. I haven't stopped trading because of my fear that markets will roll over. However, because of the formations seen here and warnings they offer, I have been forewarned to protect my trades to the downside by buying a little extra put insurance. I've been forewarned when prices break above yet-another potential right-shoulder area that I need to buy some long calls to hedge the deltas in any bearish spreads I might have on at the time.
Whether the formations perform as expected or fail to confirm, whether trendlines hold or are broken, whether prices bounce from expected Fib support or resistance, I've been given an opportunity to prepare accordingly. That's how I use technical analysis.