Trading Retracement

09/14/00 01:14:04 PM

by David Penn

Use Fibonacci numbers to help figure out when the market has given back too much. Or not enough.

Security: S&P500
Position: N/A

The Standard & Poor's 500 has seen some dramatic upside and downside moves over the first three-quarters of 2000. And if half the battle to making money in the stock market is learning when to get out, then you should have a working knowledge of retracement. Being able to plot and analyze retracement points can help investors tell the difference between a standard correction and a trend reversal. In fact, having a strategy that suggests when a downside retracement has gone too far can be part of your overall money management plan. Similarly, analyzing upside retracements after meaningful downtrends can help signal when the coast is clear for investors to climb on and ride a stock back up.

After any significant move, it is normal for the market to correct in the opposite direction with varying degrees of intensity. Because most major stock moves are overreactions, they are often followed by "corrections" which, temporarily, take some of the steam out of high-flying stocks and boost the bleak prognosis for down-on-their-luck stocks. Generally speaking, major moves tend to have intermediate-sized corrections and intermediate moves tend to have minor corrections--which is clear enough. But the problem arises: how can an investor tell the difference between a minor and intermediate correction? At the beginning of a market reaction, how can an investor tell the difference between an intermediate correction and the beginning of a new major trend?

Graphic provided by: Big Charts.

Here is where retracement can help. Retracement refers to the amount by which a correction moves against the prevailing trend. When analysts look at stocks that have begun to move against their prevailing trend (the beginning of an upward move in a bear trend or the beginning of a down move in a bull trend), they often look to 1/3, 1/2, and 2/3 retracement levels in order to gauge the magnitude of a countermove. A retracement of 1/3 is generally seen as a normal-sized correction; thus, if an index moved 30 points in one direction, a counter move or retracement of 10 points would be considered a normal retracement. Retracements of 1/2 are considered to be much more significant, perhaps even suggestive that the retracement is actually the beginning of a trend reversal. Often, by the time a stock retraces 2/3 of its previous movement, a technically-oriented analyst has already passed a verdict that the retracement has become a reversal--at least for purposes of trading.

Another set of retracement numbers that are popular among technically-oriented analysts are the Fibonacci numbers. "Rediscovered" by a medieval mathematician, the Fibonacci numbers represent an oddly reoccuring number series (1, 2, 3, 5, 8, 13, 21, 34, 55, 144, etc.) that is the basis for the construction of both the Egyptian pyramids and the Parthenon on the ancient Greeks. There is also a startling occurence of the Fibonacci series in nature. In any event, the numbers have a following among many mathematically and technically-oriented market watchers, and two popular retracement levels, 38% and 62%, have been derived from the Fibonacci series (briefly, each number in the series is approximately 62% of the following number and 38 is the inverse of 62).

The chart above of the S&P 500 Composite Index for 2000 uses retracement levels to help investors analyze price movement. In March 2000, the S&P 500 climbed 210 points to 1550 before it began falling. The index passed a 38% retracement point at 1470 before the end of the month. The 38% mark suggests some caution, but still represents a normal correction level. However, by mid-April, the index was crashing through its 62% retracement level of 1407. The index stopped falling almost 67 points later.

Retracement levels can also be helpful during bullish corrections. In July, the index fell 100 points to 1420. As the index rallied, it crossed the 38% retracement point of 1458 by early August and crossed the 62% point by mid-month. The index went on to gain another 43 points. Another interesting test of retracement levels comes as the S&P 500 in September begins a bearish reaction against August advances. As of this writing, the S&P 500 was just above its 38% retracement point of 1487. Interestingly, the index's 68% retracement point at 1463 is comparable to the highs of May. The coincidence of these factors (falling below the 68% point and losing ground to past highs) could make for bearish tidings indeed should the index find itself in this territory any time soon.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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