Bounce Likely In The R2K: Fact Or Fib?

02/09/10 08:45:50 AM

by Donald W. Pendergast, Jr.

Now that the market's fear factor is back in force, skilled technicians can use Fibonacci time cycles and EMA support to locate low-risk countertrend trade setups.

Security: RUT, IWM, TF
Position: Buy

Anyone who has traded for any length of time knows that every strong uptrend will eventually take a breather, either in the form of a consolidation or retracement move. They also realize that even the longest-lasting trend will finally reverse, usually with a lot of accompanying fireworks (panic selling or short-covering). Right now, it's difficult to discern whether the Russell 2000 index (the key small-cap stock index in the US market) is simply pulling back in anticipation of launching significantly higher or if it's in the initial stages of a major trend reversal, one that could retrace a significant amount of the astounding gains racked by this index between March 2009 and January 2010. In any case, a unique technical setup has begun to manifest, one that could enable enterprising swing traders to grab some fast profits on a well-timed long entry.

FIGURE 1: RUSSELL 2000, DAILY. With both the Fibonacci time cycles and retracement levels in agreement that a reversal is likely, the fact that the 200-day EMA is also in agreement only strengthens the case for the appearance of a tradable long entry soon.

Graphic provided by: MetaStock.

It may never be fully known how or why the Fibonacci number series works in the financial markets; some believe that there is an underlying numerical order that permeates virtually all aspects of the world we live in and that this hidden order is alive and well in the stock and commodities markets as well. Others attempt to discredit Fibonacci as a mere self-fulfilling prophecy, crass numerology, or just plain old mathematical bunk. Who knows? Maybe both the believers and the unbelivers in the Fibonacci phenomenon have a grasp of a fragment of truth. Really, though, the big question is this: Does this method work well enough to implement as part of a rational, well-thought-out trading plan?

Take a look at Figure 1, on which both the Fibonacci time cycles (since the major March 2009 low) and the 200-day exponential moving average (EMA) are both plotted, and then make your own decision. The vertical blue lines depict the Fibonacci time cycles, with the most recent one being the 233-bar time cycle. If you glance to the left, you'll note that the 144-bar, 89-bar, and 55-bar Fibonacci time cycles all came close to accurately predict significant swing turning points. Meanwhile, even a couple of the earlier time cycles did a decent job of helping patient traders time various swing termination points.

Next, witness the location of the 200-day EMA, which just so happens to be just below today's closing price of 586.00 (by about six points). There has actually already been a minor bounce off of the 200-day EMA, but we need to see how the next few sessions play out before coming to any conclusions regarding a tradable bounce. Finally, there is also a Fibonacci retracement confluence support zone (based on two separate trend swings since last March) that spans the zone between 576 and 584; see the dashed line on the chart.

Taken together, these three technical tools all seem to imply that some sort of a consolidation pause and/or a tradable long setup will be the result. One way to time a possible long swing entry could be as simple as using a stochRSI (10) indicator entry, going long on the first daily open after a bullish cross above the indicator's lower signal line (with the lower signal line usually being set to 20, with the uppper signal line set at 80). Running a three-bar trailing stop of the daily lows and then exiting either on a stopout or a rise above the upper signal line could be one way to manage such a hypothetical trade. Should such a trade make it up to 615.00 or so (the most recent minor swing high), it would be wise to take at least partial profits, as that is likely going to be a tough point of chart resistance to crack.

Bull or bear, who really cares? As traders, we can learn to align our trading strategies with whatever the market decides to throw our way. Take some time and watch how this potential trade setup works out and then see if you can't also identify similar setups in whatever stocks, exchange traded funds (ETFs) or futures contracts you normally trade.

Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title:	Writer, market consultant
Company:	Linear Trading Systems LLC
	Jacksonville, FL 32217
Phone # for sales:	904-239-9564
E-mail address:	lineartradingsys@gmail.com
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Bounce Likely In The R2K: Fact Or Fib?

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