Fibonacci Retracement Levels

Fibonacci Retracement Levels: Let “Leo” Calculate Your Support and Resistance

By Jim Stanton, Contributing Editor
Tuesday, May 30, 2006: Issue #313

As an investor, timing your trades is one of the hardest things to do. After all, knowing when to get in and out of a stock is the critical element to successful investing.

Simply put, when a stock with a bullish chart pattern pulls back near its support level, it’s a good opportunity to buy. When a stock with a bearish chart pattern rallies up near its resistance point, it’s a good opportunity to short it.

So, how exactly do you work out where a certain stock’s support and resistance points are, alerting you to the best time to buy and sell? There are a number of ways to do it, including moving averages, trend lines and historical support and resistance levels. But today, let’s focus on buying stocks on pullbacks, using Fibonacci retracement levels.

Profiting From Fibonacci: The “Father Of Mathematics”

In case you’re not familiar with Leonardo Fibonacci, he was a 12th century Italian mathematician, widely considered the “Father of Mathematics.” His theories form the Fibonacci trading technique, using a specific set of numbers known as the “Fibonacci sequence,” which the retracement concept is based on.

Basically, this states that markets do not simply move up and down in a straight line, but fluctuate along the way and establish certain key points. The Fibonacci sequence gives you an idea of how high and low these retracements are going to go, so you know when to buy and sell.

There are three main retracement levels that many traders use: 38.2%, 50%, and 61.8%. After a move up or down, the price will usually “retrace” from its highs and form support, or bounce off its lows and form resistance levels near those Fibonacci points. This can help you figure out the best point to buy and sell.

At times, I will use 23.6% and 76.4% Fibonacci retracement levels if the previous action has been extremely bullish or bearish. Many traders focus on the 50% retracement area, but the extent of the pullback depends on how bullish the stock has been acting.

For example, if the stock has performed strongly and has solid momentum, you may only get a pullback of 38.2% (23.6% if it’s been extremely bullish). But if the stock has experienced an extended downtrend, it could retrace 62.8% or possibly 76.45% in a “retest” of its previous lows.

Let’s see how this works in the real world…

The Fibonacci Retracing of Comcast… And Winning

In the June issue of the Xcelerated Profits Report newsletter, I recommended buying Comcast (Nasdaq: CMCSA) and used the daily and weekly charts to illustrate the use of Fibonacci retracement levels.

The first chart below is the weekly CMCSA chart, dating back from May 10, 2002 through 2004. As you can see, CMCSA bottomed out in October of 2002 and rallied, without much of a pullback, until June of 2003 when it reached $34.85. Since it was a fairly strong rally, you would not expect a sizable pullback and it retraced exactly 38.2% before making new highs in 2004.

Now, take a look at a more recent daily CMCSA chart below. It’s a completely different picture. The stock sank more than 25% between April 2005 and January 2006 when it hit a low of $25.33.

That triggered a buy signal, but since the prior action was very bearish, you can expect a deeper pull back because stocks often have to test lows before a change in trend can be validated. As you can see, CMCSA did test the low (a 76.4% retracement) before reversing and validating the new uptrend.

Charts Courtesy of Trade Navigator Software (http://www.genesisft.com)

Watch Your Fibonacci Retracement Levels!

If you want to try to reduce your risk by buying stocks on pullbacks (or shorting stocks on rallies), you have to watch each Fibonacci retracement level mentioned above for other potential signs of support.

For example, if you think the stock will have a sizable pullback (50% or more), but the 50-day moving average shows the 38.2% retracement level, then you have to watch that level carefully for signs of a reversal.

I rely on Fibonacci retracement levels in my stock analysis and have found that the more support there is surrounding any of these particular retracement levels, the higher the odds are that you’ll see a reversal from that area.

Like I said, though, you need to show some patience, but the upside is that you’ll know fairly quickly if your analysis is correct and can keep your losses relatively low – a critical aspect of any trading strategy.

Good Trading,

Jim Stanton