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How to tell if the market is about to change direction – Part three

Posted by Matt Dalgleish on 7 March 2016
Matt Dalgleish

This blog is the third instalment in a series on technical analysis/charting tools used to predict potential change in market trend. The purpose of these series of blog articles is to give our readers a more in depth background on a variety of technical analysis tools that can be used as a reference point for readers unfamiliar with charting.

The first article in the series entitled “How to tell if the market is about to change direction” provides a brief description of technical analysis (also known as charting) and explains the logic behind its use in commodity market forecasting. It includes an explanation of a common momentum indicator known as the Relative Strength Index (RSI) that is used by technical analysts to identify oversold or overbought markets and bullish or bearish divergence.

The second article, outlines the basics of Bollinger bands and how they relate to the use of percentile (decile) tables when comparing current price levels to historical price movements. Readers that missed these initial two blog articles may find it useful to familiarise themselves with them prior to completing this article.

Retracement levels – support and resistance

Once a change in trend for a market is identified the technical analyst will often turn their mind to forecasting how far the price correction will extend before resuming the original trend. These potential areas of support and resistance levels during a correction in price trend are often referred to as retracement levels.

Support levels always refer to areas below the current market price where fresh buying is likely to emerge, thereby supporting the price to see it recover and trend higher. Resistance levels always refer to areas above the current price where fresh selling is likely to emerge thereby acting as a barrier to price moving higher and encouraging a drift lower in price.tech_analysis_fig_1.jpg

Consider a market that has price trending upwards, also known as a bull market – figure 1. At point B, once a change in trend has been identified, the technical analyst would be using chart based tools to predict how far the market will correct (point C) before resuming the uptrend towards point D.

 

 

 

 

tech_analysis_fig_2.jpgA similar situation occurs during a market that is trending downwards, also referred to as a bear market, as displayed in figure 2. The technical analyst would be attempting to predict how high the correction in price trend from point B to C would travel before the resumption of the downtrend occurs.

There are of course a variety of methods used by a chartist to predict these potential support and resistance levels. A common method favoured by many technical analysts and market traders are Fibonacci retracement levels and this methodology is the primary focus of this article.

 

Fibonacci Sequence

Fibonacci retracement levels are based on a number sequence originally identified by mathematician Leonardo Bonacci of Pisa, also known as Fibonacci, in the thirteenth century. Mathematicians and scientists throughout the ages have identified connections between the Fibonacci sequence and many aspects of the natural sciences. Indeed, it has been described as the building block of anything that is naturally evolved.

More recently, modern day mathematicians have found strong links between the Fibonacci sequence and chaos theory mathematics. Chaos theory mathematics has been used to identify predictable patterns in seemingly random/chaotic behaviours in many scientific fields, including economics.

The basic Fibonacci sequence is derived by adding the numbers in a recurring pattern whereby each subsequent number is the sum of the previous two. Starting with the number zero and one the sequence would be as follows:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, 1597, 2584 and so on.

However, Fibonacci's sequence of numbers is not as important as the mathematical relationships, expressed as ratios, between the numbers in the series.

From the Fibonacci sequence we can derive the two key ratios of 61.8% and 38.2% used in calculating Fibonacci retracement levels.

Once you work through the initial few numbers it can be shown that by dividing any number in the Fibonacci sequence by the number that precedes it very quickly approximates to 0.618 (61.8%) and dividing any number by a number two places preceding it equates to 0.3819 (32.8%).

tech_analysis_fig_3.png

Interestingly, it doesn’t matter which two numbers start the Fibonacci sequence when applying the rule of the recurring pattern, whereby each subsequent number is the sum of the previous two, will result in the ratios between numbers will always approximate to 0.618 and 0.3819, respectively.       

For example, using 9 and 17 as the two initial numbers creates the following sequence:

9, 17, 26, 43, 69, 112, 181, 293, 474, 767, 1241 and so on.

We can see that the ratios still hold true as 767 ÷ 1241 = 0.6180 and 474 ÷ 1241 = 0.3819

Fibonacci Retracement Levels

In technical analysis, Fibonacci retracement levels are created by taking two extreme points in an identified trend. This is usually a major peak and trough on a price chart, such as point A to B in figure 3. The difference between the two points is then used to derive the relevant support or resistance levels by the Fibonacci ratios of 38.2%, and 61.8% to determine the potential retracement levels of the correction.

tech_analysis_fig_4.jpg

Working through a real life example of calculating a Fibonacci retracement level is shown in figure 4 which outlines a recent rally in the A$ against US$ on a ninety minute high low close (HLC) chart.

Taking a low of 0.7062 (point A) to a peak of 0.7254 (point B) we are able to generate a potential 61.8% retracement level of 0.7135. The calculation for this retracement is as follows:

 tech_analysis_fig_5.jpgtech_analysis_fig_5.jpg

0.7254 - 0.7062 = 0.0192               Difference between the peak in uptrend less the trough in uptrend

0.0192 x 0.618 = 0.0118                 Multiply difference by relevant Fibonacci ratio, in this case 61.8%

0.7254 - 0.0118 = 0.7135               Subtract the potential retracement from the peak to get a potential support level where the market price may continue the uptrend

 

 

Like with many aspects of technical analysis there is some skill/subjectivity in using charting tools. A competent technical analyst will never just use one method to arrive at a forecast for potential support or resistance levels. Similarly, when using Fibonacci retracement ratios there is some experience required to correctly identify the appropriate levels in an uptrend or downtrend from which to measure retracements.

Additionally, sometimes levels identified from the Fibonacci retracements do not prove to act as key support or resistance areas. Therefore, it is important to build a more robust picture of likely market price behaviour by using multiple technical tools such as Bollinger bands, RSI, moving averages, etc.

A chartist that relies solely on a Fibonacci retracement calculation to predict a potential low or high in price movement is akin to an economist only using a nations inflation figure to forecast potential currency fluctuations, ignoring such factors as GDP and interest rates.

Topics: Risk management, markets, technical analysis, trading

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