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Having the ability to forecast significant tops and bottoms is the ultimate level of achievement for any trader. This is not as easy as it seems. We have all been in the boat of entering a bullish trade at a top or a bearish trade at a bottom. After all, it is natural human behaviour and this is exactly how the average uneducated person trades. As Optionetics students we are operating on a higher level. We are taught to be momentum traders. As the adage goes, "the trend is your friend." However, there are times to sit back and not trade, as a turn may be close by. In this article I wish to show you how the recent March low occurred at a key price level using the ‘numbers of nature’ (aka Fibonacci numbers).

As technical traders we are convinced that history repeats. The market, sectors and individual stocks all trade in patterns and ratios that have been seen in the past. The key Fibonacci numbers to watch are 23.6%, 38.2%, 61.8%, 100%, 138.2% and 161.8%. Unfortunately, going into the derivation of these numbers is beyond the scope of this article. If you would like to learn more about them there are several articles in the Optionetics archives, or you can do a search through your Web browser.

I will focus on the S&P500 (SPX) because I believe this is the best index to get an overall feel of what is going on in the US market. Figure 1, below, illustrates a monthly bar chart applying the Fibonacci retracement drawing tool from ProfitSource. The tool is applied from the 1987 low of 216.46 to the 2000 high of 1552.87 and with each of the Fibonacci levels. It can be seen that the key level of 61.8% retracement level (726.97) held in 2002.

Figure 1: SPX monthly bar chart with the Fibonacci drawing tool
(click here for larger view)

After there is confirmation that this has the potential to be a significant low, then it is time to get an idea of where areas of resistance could be. To do this we need to apply the Wave Extension drawing tool in ProfitSource. Figure 2 shows this tool being applied. Notice how the 61.8% extension level held and the market pulled up just short of this level? So too the retracement down held above the 61.8% level yet the extension held below the 61.8% level. Seems like the Fibonacci levels with 61.8 in them are important!

 Figure 2: SPX monthly bar chart with the Wave Extension drawing tool

This is all good and well in hindsight, but how is this relevant to today’s market? Before answering that question, as a technical trader you must first understand that what works on a yearly chart will work on monthly, weekly, daily, hourly, and 5-minute charts. In Figure 3, below, the Wave Extension drawing tool has been applied to a daily bar chart. The 1.618 extension is clearly at work on two separate ranges. I will focus on the larger one (green lines). The market breached the 1.618 extension briefly intraday on March 17 before closing well off this level.

Figure 3: SPX daily bar chart with the Wave Extension drawing tool

Taking a look at the bigger picture and applying the Fibonacci retracement tool from the 2002 low to the 2007 high, it can be seen that the 0.382 level (1268) comes in very close to the 1.618 (1265). Only 3 points off! The more levels you have coming in around the same price, the stronger the likelihood of it being a key support/resistance level. Figure 4 demonstrates this.

Figure 4: Weekly bar chart with the Fibonacci retracement tool

What if you don’t have ProfitSource? Easy! With whichever charting software you use, take a pen and calculator or use Excel and plot the key levels on yourself. How can you use this with your trading? Have the key levels on your chart and don’t enter a trade just shy of these levels. Wait for them to be broken and then enter a trade with the trend. Conversely, if you see signs of a reversal around these levels, wait for confirmation from your technical analysis tools (moving averages, crossing of recent tops/bottoms, OBV, RSI…) to trigger your entries.

Where to from here? Well, if the market continues its recent strength, then 1534 to 1576 (October high) will be a potential resistance level. Should the market break down then the price of 1077 (61.8%) from Figure 4 is a logical target. We now have two scenarios in mind, so nothing will take us by surprise. This is not a bad way to be. Simply trade with the trend.

Make it happen!


Guy Halpin
Senior Writer & Options Strategist
Optionetics.com.au ~ Your Options Education Site

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