Market trends never take place in straight lines. Most trend pictures show a series of zigzags with several corrections against the prevailing trend. These corrections usually fall into certain predictable percentage parameters. Historically, the market has shown to move in either 3-day or 5- day increments.
Meaning, in an uptrend, the market historically has either three days advance before a slight pullback, or five days advance before a slight pullback. The same holds true in a declining market. Meaning, you will normally see either three days or five days down before a bounce back.
3.2 Key Indicator
A key indicator in studying this is the amount of retracement that the market, and/or a stock, retraces after an advance or decline. The best-known example of this is the fifty-percent retracement. That is to say, a secondary, or intermediate, correction against a major uptrend often retraces about half of the prior uptrend before the bull trend is again resumed.
This tells us that if your stock is in an uptrend, then after a decline, it advances Rs.50 in price without a pullback, then during a pullback, it should retrace no more than about 50%, or Rs.25. Retracing more than 50% after advancing is a sign of weakness and at a minimum should be noted and watched closely.
Bear market bounces often recover about half of the prior downtrend. A minimum retracement is usually about one-third of the prior trend. The two-thirds point is considered the maximum retracement that is allowed if the prior trend is going to resume. A retracement beyond the two-thirds point usually warns of a trend reversal in progress.
Chartists also place importance on retracements of 38% and 62% which are called Fibonacci retracements.
3.3 Fibonacci Analysis
Fibonacci analysis is the study of identifying potential support and resistance levels in the future based on past price trends and reversals. Fibonacci analysis is based on the mathematical discoveries of Leonardo Pisano, also known as Fibonacci. He is credited with discovering a sequence of numbers that now bears his name: the Fibonacci sequence.
The Fibonacci sequence is a series of numbers that progresses as follows, 0,1, 1, 2, 3,5, 8, 13, 21, 34, 55 To arrive at each subsequent number in the sequence, you simply sum the two preceding numbers in the sequence. For example, to find the number that follows 55 in the sequence, you add 55 + 34 (the two preceding numbers in the sequence). The sum of 55 + 34 is 89. This is the next number in the sequence.
What intrigued Fibonacci about this sequence was not the numbers themselves but rather the relationships among the numbers, or the ratios created by various numbers in the sequence. Perhaps the most important ratio is 1.618, also known as the golden ratio, or golden mean. This number can be found throughout nature (in sea shells, growth rings, etc.) and throughout the Fibonacci sequence. Each number in the Fibonacci sequence is 1.618 times larger than the preceding number. For example, 89 is 1.618 times larger than 55 (89/55 = 1.618).
3.4 Fibonacci Retracements
When a stock price reverses trend, traders naturally want to know how far the stock is most likely to move in its new direction. Fibonacci retracement levels can help. Certain Fibonacci ratios are useful when you are trying to determine how far a stock is going to retrace, or move against, a previous trend.
The ratios you will be using in your trading will help you find the following retracement levels:
8 percent- This level is found by dividing a number in the Fibonacci sequence by the number immediately following it in the sequence (55/89 = 61.8%).
2 percent- This level is found by dividing a number in the Fibonacci sequence by the second number following it in the sequence (34/89 = 38.2%).
6 percent- This level is found by dividing a number in the Fibonacci sequence by the third number following it in the sequence (21/89 = 23.6%).
You will also use three other levels in your retracement analysis. While the following levels are not calculated using numbers within the Fibonacci sequence, they are based on the Fibonacci levels above:
50 percent-This level is determined by finding the middle between 61.8 percent and 38.2 percent ((61.8% + 38.2%)/2 = 50%).
4 percent-This level is determined by finding the distance from 38.2 percent and 23.6 percent (38.2% - 23.6% = 14.6%) and adding it to 61.8 percent (61.8% + 14.6% = 76.4%).
100 percent-This level is determined simply by finding where the previous trend began.
Determining all six Fibonacci retracement levels provides you with potential support and resistance levels you can use in your trading.
3.5 Usage Of Fibonacci Retracement In Stock Market
Fibonacci retracements can also be applied to stocks that are falling, in order to identify the levels up to which the stock can bounce back.
In the chart below (Cipla), the stock rose from around Rs 384 level recorded way back in May 2014 to Rs 751 levels in March 2015. (This illustration is only for information and not a recommendation on the stock).
Let's apply the Fibonacci retracements, when the stock started falling in order to identify levels up to which it can bounce back to. In the chart below (Cipla), the stock started to decline from a high of Rs 751 and broke below key support levels as per Fibonacci series, but finally took support at 23.6 percent retracement and bounced back.
Think of a situation where you wanted to buy a particular stock but you have not been able to do so because of a sharp runup in the stock.
In such a situation, the most prudent action to take would be to wait for a retracement in the stock price. Fibonacci retracement levels such as 61.8%, 38.2% and 23.6% act as potential levels up to which a stock can correct.
The first level to watch out would be 61.8 percent, which provided strong support for the stock in the past. The stock chart shows that it had bounced back from that level seven times in the past. Hence, a break below that level fuelled further downside in the stock and it went on declining towards 23.6 percent retracement before moving higher.
Going forward, for a sustained upward move, the stock has to surpass 50 percent and then 61.8 percent resistance levels convincingly.