S&P 500 Fibonacci Retracement

One of the more interesting and esoteric technical trading tools is the Fibonacci Retracement.  For those not familiar, the retracement breaks down a particular range into five percentiles (seven including the maximum and minimum).  The key numbers are 0%, 23.6%, 38.2%, 50%, 61.8%, 76.4% and 100% (0% and 100% are obviously the max and min).  The biggest problem we see with this kind of analysis is the fact that it is backward looking.  The chart shown immediately below illustrates the S&P 500 over the last year, with the key lines drawn. 

 

As shown, the market bottomed beautifully on the 50% line in August-07 and November -07.  The problem: a new bottom has been made since then (March-08) low and the chart as of 12/31/07 would have appeared as shown below:

Quite different, although the bottoms do still occur at one of the key lines.  Another difficulty when examining retracements is determining appropriate maximum and minimum values.  When we looked at the last year (the first chart) we see that after bottoming the S&P 500 rallied to just above the 50% line which also coincided with the 200-day moving average making a strong case for resistance.  Below we show another retracement beginning on 10/9/02; the start of the 2002 bull market as defined by Birinyi Associates.  As shown, the 61.8% line came into play at the March bottom, while the 76.4% line is currently in play as some possible support.

Our problem with this indicator is that while it looks enticing and accurate on the chart, the market rarely turns "on the line."   If we look at the chart of 2007, and say we had bought the market on the 23.6% line at 1420 on 1/4/08 our investment would have declined to 1270 (-10.5%) over the next two weeks.  In hindsight that may count as a breakdown, at the time we would have been buying on support.  Bottom line: the charts are interesting and sometimes surprising, but are less useful as investment tools.

Comments

[Andy Askey]

One thing that would help you use these price level aides is to add time cycles. You mention that a low (or high) is only a low (or high) until it is exceeded. If you use the time frame of the original move as a guide, then the levels will be valid during a time cycle equal to the original range. Actually, you will see the 50% price retrace level is very often hit at exactly 50% of the time of the original range.

I'm glad that well-known and trusted firms discount technical analysis. It discourages other people from using it, and therefore creates profitable oppurtunities for me. If everyone was looking at the same indicators, there would be no way to profit from them. Thanks!

[Carl]

In hindsight, Fibonacci retracements are eerily accurate.

But in real-time, how can a trader/investor know which Fib level (23.6%, 38.2%, 50%, 61.8%, or 76.4%) is the money shot?

Here's some insight into how monitoring the level of Buy Programs and Sell Programs in the electronic futures markets can give indications as to which level dominates in any given setup.

http://www.transactionlevelanalysis.com/2008/06/how-to-overcome-the-core-compl.html

Hope that you find this interesting.

C