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Separating the Retracements from the Reversals

Separating the Retracements from the Reversals
April 26
04:31 2012

We have previously discussed the Elliott wave and how, if properly identified, it can forecast the upward and—more reliably, since more of the pattern is visible for confirmation—downward movement of a stock or ETF price. The main challenge of shorting a wave 5 peak is determining where to exit the trade, and that is where the Fibonacci retracement comes in.

We have also discussed the basics of Fibonacci ratios for determining resistance and support levels. The basic principle is that the three corrective waves of an Elliott wave pattern should take the price to around the 38.2% support line—in other words, a 61.8% retracement of the upward movement—at a maximum. (This is at the bottom of the C wave, mind you, not just the initial A wave down.) Remember that there are other support levels, and in many cases the A-B-C waves down may take the price only to the 50% line. This is why it’s important to combine other indicators with the Elliott wave and Fibonacci ratios—while they are fairly reliable, there are multiple support lines, and no guarantees as to which one will ultimately put the floor under the equity you’re trading.

In some cases, however, you won’t be presented with a neat Elliott pattern. After all, stock prices can move in a number of different ways, many of which don’t presently neatly and obviously on a chart. So here we’ll discuss ways to analyze down periods in an otherwise up-trending stock to determine whether you’re seeing a minor correction—a retracement—or a full-blown reversal.

The first indicator is volume, always a handy clue as to who’s doing the trading. Volume that’s in line with recent levels shows that activity is confined to minor market players like individual investors, and probably means a retracement. If volume spikes well above average on declines, however, that means large institutional investors have gotten involved, and you can expect a reversal.

Next is trader sentiment. If buying interest still exists, you are looking at a retracement. When buying interest dries up almost entirely, traders have lost confidence, there is nothing left to drive upward movement, and a reversal is coming.

Then there is short interest—the vultures gathering for a meal. If it remains flat, think retracement. If it spikes, figure on reversal.

Prior price activity is also a clue. Retracements are very common after a strong upsurge as traders take profits. A sudden downward swing that seems to come out of the blue—or more commonly, after a period of sideways movement as the stock loses momentum—is likely to be a reversal. Consider timeframe as well. Retracements are fairly quick and should last no more than two weeks at the most. Beyond that, the underlying price trend has probably changed.

You should also consider fundamentals, even if you’re a dyed-in-the-wool technical trader. If there have been no significant changes to the company’s fundamentals, there is no reason to expect a reversal, but if bad news has come out (or there is strong buzz about expected bad news), look out.

Of course, you can also look for classic reversal chart patterns, such as the double top or head-and-shoulders (to name just a couple), but as those form longer-term, you might have already seen them coming. Candlesticks can also provide hints. “Indecisive” candlesticks, with short bodies and long wicks, are usually characteristic of retracements, whereas engulfing patterns and black crows tend to signal reversals.

Finally, getting back to our Fibonacci ratios, a single-wave retracement (as opposed to the full three down waves of an Elliott pattern) should be no more than 38.2%. If it exceeds that, start watching for the reversal.

Sometimes it may be necessary to evaluate multiple signals to get a clear idea of what is happening, but take the time to do so. Determining accurately whether you need exit a position or hold on through the turbulence before continuing the ride up can garner you profits you would otherwise have forfeited or cut your losses just in time when things head south.

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