Current Monthly Trading Article

Frequently, fundamentally sound stocks undergoing accumulation do so through multi-day pullbacks (i.e., by making a series of lower daily highs) before entering longer periods of consolidation where multi-week “cup & handle” or range-bound patterns form. One advantage buying these pullbacks offers is their well-defined trade management criteria (SE chart insert): entry points (buying when today’s price exceeds yesterday’s high) and stop-loss points (selling below the low of the pullback. Another is their predictability, both in depth and duration. Examples are evident in SE’s daily chart where a variety of multi-day pullbacks are identified by letters a through p.

The market psychology leading to pullback formation is understood best in terms of alternating buying and selling pressures as price first rises then pulls back. Fundamentally sound companies draw buyers and buying pressure dominates, then price rises to the point where owners worry about the profits they’ve earned. And short sellers step in. A pullback results as selling pressure takes over, and price falls for a few days to the point where buyers recognize a bargain and return.

To give you an idea of their frequency, I evaluated for 2003, the number and the length of pullbacks for fundamentally sound market leaders cross-screened against Zacks 1&2 rankings: a sample of 19,960 trading days from 88 stocks. Using the additional criteria that only those pullbacks occurring in an environment where their 50-day moving average was rising, 28.7% of those days were in pullback: 13.2%(1 day), 7.6%(2 day), 4.1%(3 day), 2.1%(4 days), 1.0%(5 days), 0.4%(6 days), and 0.3%(>6 days). Several are evident on the SE chart. For stocks of this quality, pullbacks greater than three days are rare and usually buyable.

The SE chart demonstrates typical pullback structures. Once it begins, price frequently falls to an area of prior support: (1) an area where price has reversed earlier, e.g, the depth of valley c reaches mid July’s peak; (2) the vicinity of a major moving average, e.g., SE often reversed at its 20-day moving average; or (3) the depth near common Fibonacci ratios (38.2%, 50%, or 61.8%), e.g., b to c reverses 39.3% of the a to b rise, d to e reverses 33.2% of the c to d rise, f to g reverses 65.4% of the e to f rise, m to n reverses 55.3% of the i to m rise, and o to p reverses 64.7% of the n to o rise. Other features mark the coming pullback’s reversal: narrowing daily bars, a reversal of the open high-close low pattern, increased volume, and a long-tailed candle formation (a “hammer”).

Fibonacci ratios likely measure the balance between human fear and greed, i.e., as price falls fear dominates, and sellers rule, but a point is reached where greed enters, buyers again rule, and price climbs. I recently poled a group of 121 traders pictorially for their preference in initiating the reversal of a pullback. They were shown a picture of rising daily bars and asked to choose a point at which they thought a pullback would be reversed: 2% chose a 12% reversal, 0% a 19% reversal, 5% a 27% reversal, 77% either 38, 50, or 62% reversal, 9% a 75% reversal, and 5% a 91% reversal. It’s natural for us to initiate the reversal over a range close to the Fibonaccis.

 

The Fibonacci Series

“1—1—2—3—5—8—13—21—34—55—89—144—233—377—610—to infinity”

This famous sequence of numbers, in which each number is derived as the sum of its two preceding numbers, appears in areas as diverse as nature, mathematics, and architecture: the leaf arrangement of common plants, the spiral shell of the chambered nautilus, the sets of spirals evident in the arrangement of pinecone seedlings, even the lengths of the longest to shortest bone in your fingers are examples. Mathematically, the ratio of a larger number in this series to its immediate precursor (e.g., 610/377 = 1.618) approaches the “Golden Ratio,” which also has interesting properties. For example, one obtains the square of the ratio by simply adding one (i.e., (1.618)^2 = 2.618), and the forward ratio equals the reverse ratio minus one (i.e., 377/610 = 0.618).

Fibonacci numbers and their ratios have influenced art and architecture over the centuries. To quote Trudi Garland in Fascinating Fibonaccis: “There seems to be a visually pleasing quality to these numbers and their relationship to each other that has appealed to humanity’s sense of beauty since the beginning of recorded history.” The exterior dimensions of Athens’ Parthenon, built in 440 BC, were built using the proportions of the golden ratio, and Leonardo da Vinci also used this “divine” proportion in his Mona Lisa.

I think that this famous ratio also reflects the human balance of fear and greed that plays out time and again daily in the market. As Derrik Hobbs said in Fibonacci for the Active Trader: “…Fibonacci is the mathematical structure of the growth and decay of psychological interest in a stock. By understanding this structure you can identify where the emotional shifts between euphoria and pessimism in the markets will come.”