Thursday, April 30, 2009

Start 'Charting' Your Path to Profits With the 50% Retracement Rule

by Chris Rowe.

Since early March, demand has been in control of the stock market, and this trend is set to continue for the intermediate term (i.e., weeks to months).

To stay ahead of the market curve, I've been reducing bullish exposure lately, as I have seen signs of weakness in the stock market. But, nonetheless, demand is still in control until further notice. So, if there are some stocks that you want to take a bullish position in, you might be asking yourself when the best time to buy would be.

You Don't Have to Wait for a Bull Market to Be a Buyer

First of all, what you want to do, if you are going to be bullish, is to buy the strongest stocks within the strongest sectors -- but you want to buy them on a pullback.

But, how do we know how much a stock is going to retreat before its next advance?

There are a number of ways to predict a stock's behavior, most having to do with past support levels.

A stock's support level is exactly what it sounds like -- a floor through which the stock has trouble breaking. The opposite term is resistance, which is a ceiling through which a stock has difficulty penetrating. When a stock is trading between these two levels, it is said to be in a trading channel.

I have a number of simple indicators that I use to decide what to trade and when, some of which come in the form of popular moving averages and trendlines.

But today I'm going to go over one of the most basic "technical analysis 101" principles that will lay down a foundation for understanding how far a stock is likely to retreat before the next bull run.

Don't forget, these are just the basics, but knowing them will help increase your accuracy, especially when you consider the following principle in conjunction with identification of past support and resistance levels.

The Secret is Not So Secret After All -- Just Trade the Trend!

Bottom line, you always want to trade in the direction of the trend. And a trend is obviously a series of zig-zags. These zig-zags move in the direction of the trend and then retrace before continuing in that same direction. (Like I said, it's technical analysis 101.)

While secondary parameters are set at 33% and 66% (as outlined in the chart above), the most-common percentage retracement before resumption is the (approximately) 50% retracement.

I know, this might sound absolutely crazy if this is your first time hearing it, but if you look at a bunch of stock or index charts after reading this article and apply these percentage retracement principles, you'll be absolutely amazed!

Two Steps Forward, One Step Back

The way that traders use this application, for example, would be to look for approximately a 5-point retracement after a stock advances by 10 points from a low to a new high (because 5 points is 50% of the 10-point gain).

So, when a stock trades 10 points higher from $15 to $25 and then reverses lower, traders would look for support around $20.

Again, this is certainly not a strict rule, and the secondary parameters wouldn't have been set near 33% and 66% if it were. In fact, other theories set retracement parameters around 62% and 38%, while maintaining the 50% point as the average retracement.

Secondary Parameters

When it comes to retracements, 66% is a critical area. For instance, in the case of an uptrend, if a stock advances higher, and then retraces 66% of the recent move and starts to bounce higher again, it's considered to be a relatively low-risk buying opportunity.

But if the 66% retracement area is violated (if the stock retraces by more than 66%), a reversal of the prior uptrend is very likely.

This is also true in the case of a downtrend, so listen up if you are looking for a good place to enter bearish positions to take advantage of the next downtrend in the general stock market. (Learn How to Pick the Right Put Option.)

If a downtrending stock retraces about 66% of the recent decline and begins to resume its downtrend, that area is a good place to sell short the stock or buy put options. If the downtrending stock retraces more than 66% of the recent decline, then the downtrend is likely to reverse to an uptrend.

In 'Support' of Trading on Retracements

Let's take a look at how to find retracements, which can serve as fantastic buying opportunities.

• he stock moves from about $2.20 to about $3.50 (not counting intraday movements). This is a $1.30 advance, half of which is 65 cents. The stock retraced by about 60 cents. (This retracement also coincided with the gap higher, which tends to act as the new support level.)
• The stock then moves from about $2.90 to $3.25 (a 35-cent move). Fifty percent of that is 17.5 cents. The stock retraced by nearly that amount before moving higher.
• Then focus on the blue box. You can see that after a 50% pullback, the stock gapped even lower, and the trend reversed from an uptrend to a downtrend.
• Between August and September, the stock traded from about $2.60 to $3.20 (a 60-cent move), followed by a retracement of about 30 cents.
• Then, if you check out the blue line, the intermediate move was from $2.90 to about $4.20 (a $1.30 move), followed by a retracement of nearly 65 cents.
• If you look at many of the short-term retracements and resumptions within the intermediate move (blue line), you'll see similar action.

This chart happens to have lots of 50% retracements. But remember the secondary parameters, and try to match them with past established support or resistance levels to estimate retracements.

And remember, this is a very basic principle. I thought I would give you something today that was far from complex. The good news is that other, more "sophisticated" parameters that traders look for are just as easy to understand!

Good investing, Kingsley.

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