What
Goes Down Must Come up
The stock market, and more particularly, individual charts, often
show an astounding degree of symmetry. As with nature itself, patterns
emerge from seeming chaos for those who care to look for them.
Chart analysis is by definition a study of patterns of price and
volume, though so many of its students are unaware of this primary
tenant.
If you do indeed
look for these patterns, it certainly won’t
take long to find them. I have my charting software set up to show
me a chart of the Dow Jones Industrial Average first as I open
the program. As my program opened this morning, an example
of what I am going to teach you was right there for the viewing.
Dow Jones Industrial Average
Notice that
in the area circled in red, something of a mirror image is apparent.
After price had dropped from the 9000 point
range, it turned right around and ascended back to the 9000 range.
Interestingly, these price gymnastics were accomplished in about
the same time spans. That is, the time it took for prices to drop
was about the same time it took for them to return to their former
heights.
A Journey into the Esoteric
At the risk
of putting you off, I must introduce you to a fascinating tool
that demonstrates
what I’ve been telling you about.
Now, don’t get caught up in the detail. Just take in the
big picture here.
This tool is called the Fibonacci Retracement. It is based, mathematically,
on number sequences that were first described by an Italian mathematician,
Leonardo Fibonacci, in about 1200. Fibonacci numbers are a sequence
of numbers in which each successive number is the sum of the two
previous numbers:
1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, etc.
This numerical pattern has been applied to the study of price
charts with the tool I mentioned, the Fibonacci Retracement.
Below, I’ve added
a Fibonacci Retracement to the same chart and time period we
looked at above.
Dow Jones Industrial Average
Notice
the percentages listed to the left of each horizontal reference
line. They run from zero % at the bottom to 100% at the top.
After prices fall and then begin turning back up, we can apply
the Fibonacci
Retracement to a chart. We then can watch as prices retrace their
previous drop. This Retracement is viewed as a percentage.
The Money Making Part
What we find,
as we use the Fibonacci Retracement, is that prices tend to retrace
to the percentages based on the Fibonacci sequence.
That means that, as price approaches 23.6%, 28.2%, 50%, 61.8% and
100%, we look for the price retracement to end. In trading, perhaps,
the most challenging task is to know when to take profit; this
is where the Fibonacci Retracement tool comes in. If price rebounds
to the 50% line, for example, and then begins to retreat, we have
a signal to take profit. If, as is seen on this chart, price moves
up past the 50% line, we then look to the 61.8% reference line
as a possible profit-taking point. If this one is broken, we then
look toward the 100% line.
Notice that
price moved to the 100% retracement line and then failed. This
is nearly the exact price point as was seen at the beginning
of the price drop that preceded the retracement! In fact, the
closing
price on the day before the major drop, and the 100% retracement
price, are within 10 points of each other! This is in an index
trading at 9000 points, making the difference only about .001%.
Real Life
If this is
new to you, I don’t expect you to run out and
start drawing Fibonacci Retracement studies on charts this afternoon.
You’ll need a bit more background. Though these indicators
can be figured by hand, having the right software makes it far
easier. The particulars of how to use this tool are detailed in
the Windows to Wealth series or in the Advanced Technical
Analysis course that I periodically teach for
Enlightened Millionaire Institute members.
The point here is that Stock Market price changes often unfold
in identifiable patterns that appear over and over again. Because
of this, we can clearly take advantage of this phenomenon for profit.
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