After an 8% market correction that ended in early February, the S&P started on an impressive rally that ended on April 26th. During that period, the S&P advanced approximately 14.5%. On February 25th, the S&P began using the 20-day moving average as support. I have indicated where the S&P used the 20-day as support with green arrows on the chart below. The S&P finally dropped below its 20-day moving average on On 4/27. This is considered by to be a bearish indicator. On 5/4, the 10-day moving average fell below the 20-day moving average. Many traders will switch from going long to short when they see that type of crossover. However, remember that moving averages are lagging indicators and can be prone to whipsaws (multiple consecutive crossovers resulting in false signals). If you look at 2/22, you will see that there was a bullish crossover of the 10-day over the 20-day. That was thirteen days after the rally had already begun.
Once it becomes evident that a stock may be in for a correction, people begin to wonder how far it is will drop. In order to arrive at some estimates, you need to look for likely support levels. As stated in a previous article, common moving averages such as the 50, 100, and 200-day moving averages are likely targets. On 5/4 (the light blue arrow), the market clearly bounced off the 50-day moving average. The subsequent day it opened below the 50-day. Other common price levels for a stock to find support are areas of demand. Where there was previous resistance that has been broke, the general rule of thumb is this price now serves as support. 1150 in this case, because of the strong resistance at that level in mid January. Instead of the S&P falling to any of those areas of support, the market closed at a Fibonacci retracement level.
In technical analysis, common retracements of a stock occur at 38.2%, 50%, 61.8%, and 100%. These percentages are all Fibonacci numbers. Why would a stock retrace to these levels? Some people argue it's another case of Fibonacci numbers occurring in nature. Personally, I think it's another case of a self-fulfilling prophecy, but I don't think it is worth arguing over why it works just as long as it actually does work. In order to determine the Fibonacci retracement levels, I took the lowest and highest prices achieved from the rally bottom on February 5th to the rally top on April 26th. The charting software then automatically determines where the Fibonacci levels are located. If you look at the chart above, you can see that on 5/6 the S&P closed at exactly a 50% retracement of its previous rally.* Why is predicting that information useful? Well, if you were short the market that day, you would have an idea of where to cover your short. Or, if you were long, you would have some idea of how much more pain to expect. Since this level serves as some support, the market may rally off of it. Or, it may just serve as a breathing point before the market continues lower (likely to another major level of support.)
*At the time I captured the picture of the chart, there had not yet been a cancellation of a large number of trades that had occurred on 5/6/2010. Once those trades were invalidated, the S&P's official closing price was changed to 1128.15. Given that before these changes were made, the closing price of the S&P was at the 50% retracement level, I believe that the data is still valid.
Support levels do not always work, but they work often enough that they are extremely useful. PMC often tries to buy stocks at or near major support levels. It provides a little insurance that the stock will not go significantly lower. Ideally, you can purchase a stock with multiple support levels directly under where you are purchasing it. Think of them as potential safety nets to break the stock’s fall. It is all too common that if a stock breaks one support level it will drop until it reaches the next one. There are real reasons for why this happens. People have stop loss orders right below support levels that will sell their stock automatically if that level is breached. Traders will get short a stock that has broken a support level and will not cover their short until they reach the next support level. If you know what price levels of a stock or index where the demand is likely to increase, then you can gain a predictive edge against people that completely ignore this information.
If I haven’t yet convinced you that Fibonacci's and moving averages can affect the intraday fluctuations and closing prices of stocks, let's look at what happened to the S&P on Friday, 5/7. In this first chart you can see that the S&P had its intraday low occur just below the 200-day moving average, here pointed out with a green arrow.
Now, look at where the S&P closed for the day. Though it looks like it closed slightly below 61.8%, on smaller time scale charts, like a 5-minute chart, or hourly chart, you can see that the market closed only very narrowly above 61.8%; reaffirming 61.8% retracement as a support level.
The previous two charts were both daily charts, but I want to demonstrate how moving averages also work on other time frames. Below is a weekly chart of the S&P 500. Thursday was one of the craziest days the stock market has ever experienced. Many members of the media were asking what caused the market to turn around so suddenly. Well, the chart below shows you exactly why that happened. Take a look at the green arrow. The market bottomed at the 50-week moving average. Once this occurred, people, and more importantly, automated trading algorithms switched from being short to being long. Even in times of market madness, it can follow predictable patterns. Interesting stuff, eh?
I hope you can see from these examples how powerful moving averages and Fibonacci levels are over market fluctuations. As previously stated, they do not always work. Even when they do work it is often difficult to know exactly which levels are the ones to watch for. Having a long history of following a stock and its price movements can increase the accuracy of your predictions.
If you like the information provided in the article but would prefer for an investment advisory to handle your investment decisions, please feel free to contact us at panopticmc@gmail.com.
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