NOTE: My Trader's Corner, PART 1 of "Surprises or Not With 'Rounding Tops' and 'Retracements' (3/30/14)" dealing with rounding top patterns as a chart analysis tool, can be seen online by clicking on the following LINK.

RETRACEMENT THEORY:

Analysis of retracement levels add value in predicting possible trend turning points. It's a theory as we can't define exactly how to USE retracements in all instances, especially retracements of prior price swings of the Fibonacci variety. If we can't use retracement analysis 'mechanically', their use can't be proven the way that, for example, use of moving average crossovers can be back-tested to see how profitable they were over a prior period.

However, with experience traders can often predict turning points in a stock or index such as predicting the point where a downtrend may end and an uptrend begin, especially when a rebound resumes a prior dominant trend. The same is true of the analysis of retracements of an advance as to when such a countertrend move might end in a bear trend.

I'm writing here focused on current index patterns. Specifically how the use of Fibonacci retracements suggests that the recent downside correction, especially in the Nasdaq, may have run its course.

For someone not versed in the history of retracement use, I provide a background. If you know this already or its not of compelling interest, skip to the current index charts further on.

HISTORY AND USE OF RETRACEMENT OBSERVATIONS:

We owe some debt to Charles Dow back in the late 1800's for his observations that an intermediate Market trend often will retrace (give back) anywhere from around 1/3 to 2/3rds of the distance covered by the MAJOR trend, before the major trend resumes. There were further refinements on retracements made by W.D. Gann, a famous stock and commodities speculator of the first half of the 1900's. 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 per cent.

The origins of one of the most useful 'retracement' theories for stocks and other markets came from someone who lived in the middle ages no less and was studying the population growth of rabbits. Yes, rabbits! Leonardo Fibonacci was an Italian mathematician who was doing such work in the early 1200s. 1200 is centuries before we had organized financial markets.

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.

There are technical indicators whose formulas rely on the Fibonacci number sequence, but the main application is to use the so-called '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). Have I lost you? We’ll stick to the shorthand and round off to 38% and 62%.

Also, as I used to say in my work for CNBC and I noted in my Essential Technical Analysis book, this is a 'little bit' more or less than 50%; the little 'bit' being an eighth (12.5) of a dollar either way. Of course (well maybe not 'of course' for younger traders), stocks used to be traded in eighth of a point (dollar) increments before the advent of decimal trading.

What I find most useful in trading is to track what would constitute the 38, 50 and 62% retracement levels of either an upside or downside correction. With the addition of seeing what would be a 25% retracement for a shallow correction and 75% for a deep one. Use of these retracements is a very common practice and a quite popular point of reference among profession 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 common retracements!

You can set most all charting applications to calculate retracements ranging from 25% to 38% (.38), 50%, 62% and 75% by pointing first at the low, then the high (pullback retracements) or first at the high, then the low (for retracement rallies in a downtrend). I mostly set my retracement study to see 38, 50 and 62 percent retracements, with the addition of using the 2/3rds. (66%) retracement level as rallies or declines can overshoot 62% by a bit; that 'bit' often turns out to equal a 66% retracement.

In a decline within a dominant downtrend as seen recently (charts below), I look to see if a recent low represented a 38, 50, or 62% retracement of the Low relative to the prior price peak and the starting point of a decline. If the (down) swing Low also occurred at or in the area of a key up trendline and was accompanied by an oversold, it's reasonable to assume that a low may be in place.



DOWNSIDE RETRACEMENTS OF PRIOR ADVANCES IN SOME KEY INDICES:

The following 3 daily charts, that of the S&P 500 (SPX), the Dow 30 (INDU) and the Nasdaq 100 (NDX), highlight downside percent retracements to date (as of 3/31/14) of the last advance, ranging from the smallest retracement (SPX at a 30% retracement to date), to the largest (NDX at a 62% retracement).




SOME TRADING RULES OF THUMB RELATED TO RETRACEMENTS:

These guidelines mostly are related to the most common retracements, that of the fibonacci 38, 50 and 62% retracements.

1.) A strong trend, either up or down, will usually see only a minimal price Retracement; e.g., around 1/3 to 38% (sometimes only 25%). If prices start to hold around this 'minimal' retracement area, this action may be suggesting trade exit or entry, as a deeper correction may not occur.

2.) A 'normal' trend, not powered by something extraordinary, will often see a retracement develop of about half or 50% of the prior move in stocks and the major indices. The most common level to buy or sell is this retracement amount, with an exit if the retracement continues on much beyond 50%; e.g., 5% more.

3.) Within the range of a 'normal' retracement, but not evidence of a particularly strong trend, will be a retracement of 62% or perhaps 2/3rds (66%), especially in more volatile stocks. If prices hold this area, it's also a good target for initiating bullish or bearish positions with an exit if the retracement in question exceeds 66%.

4.) If a retracement exceeds one retracement level, the price move may go to the next retracement level; e.g., if a retracement goes beyond 38%, it may go on and approach a 1/2 50% retracement. If a retracement exceeds 50%, look for 62%. If a retracement exceeds 62%, or a maximum of 66%, what may next develop is a 'round trip' return back to the prior low or high. Such a pattern suggesting a possible retest of the prior Low or High; this is ultimate 'retracement' so to speak, which is 100 percent.

5.) Retracements are most commonly done from the intraday (or, intraweek) Low to High or High to Low, which isn't based on the highest Close to the Lowest Close and vice versa. However you can also experiment with retracements based on Closing levels only (i.e., using line or Close-only charts) as they can also be 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.

REMEMBER:

In a strong advance or declining trend, a 'typical' retracement will be shallow; e.g., 25 to 33 to 38%.

In a trend advancing or declining at what has been an average rate of change, up or down, a typical retracement or give back is around half.

In a trend that is not showing a strong rate of change, a retracement may be more than stocks in that group; or, in an index that has been lagging other stronger Market sectors, an upside or downside retracement in the 62 to 66 percent area may develop.


GOOD TRADING SUCCESS!