The search for support
10/26/18

●On Wednesday the S&P 500 broke support and fell to its lowest level since May

●Popular retracement level roughly coincides with February-April lows


 

Let’s get real. As welcome a respite as yesterday’s rally was for long-term investors, it remains to be seen whether Wednesday’s low will turn out to be a significant bottom or the latest rest stop on the way to lower lows. After all, the S&P 500 (SPX) rebounded for three days and 3% after the October 11 low before turning lower again.

Traders need to consider all possibilities—and probabilities. It’s not about panic, it’s about practicality—and planning for potential trades, long or short. Consider that as of Wednesday:

●The Nasdaq 100 (NDX) dipped into correction territory, having fallen more than 10% from its August 29 high close of 7,660.16.

●The Russell 2000 (RUT) moved halfway between correction and bear-market territory, down a little more than 15% from its August peak, and came within around five points of matching its February correction low close.

In terms of the broad market, after blowing through its early October (and late-June and late-May) lows, the SPX on Wednesday found itself at its lowest point since May 4, with not much standing between it and a couple of conspicuous chart support levels—the May 3 low around 2,595 and the 2,530-2,555 zone encompassing the February and April lows:

S&P 500 (SPX), 1/26/18–10/25/18. S&P 500 (SPX) price chart. Downside support.

Source: OptionsHouse

That lower zone may have more “psychological” importance, as it represents the initial February correction low and the successful “test” of that level in April. A break below it now would imply, from a technical perspective, that the correction may not have been an aberration. But let’s not get too far ahead of ourselves.

The longer-term SPX chart below offers a perspective of the rally from the early 2016 lows to this September’s record high. Three hypothetical retracement levels are highlighted at the right side of the chart: 38.2%, 50%, and 61.8%, which are derived from the “Fibonacci series,” a number sequence in which each successive number is the sum of the two numbers preceding it (i.e., 1, 2, 3, 5, 8, 13, 21, 34, 55…etc.)

S&P 500 (SPX), 12/04/15–10/25/18. S&P 500 (SPX) price chart. Levels align.

Source: OptionsHouse

You can go down a lot of rabbit holes discussing the properties of the Fibonacci series and the significance some people attach to it, but the CliffNotes takeaway is that many traders and analysts use ratios of Fibonacci numbers to forecast price moves, with 38.2%, 50%, and 61.8% being the most popular in terms of price retracements:

●38.2% = the ratio of a number in the series to the number two after it (e.g., 21/34 = 0.382)

●50% = the ratio of the first two numbers in the series (e.g., 1/2 = 0.5)

●61.8% = the ratio of a number in the series to the one immediately after it (e.g., 21/34 = 0.618)

These ratios are translated into retracement levels by measuring a price move (say, the February 2016–September 2018 SPX uptrend), multiplying that move by a Fibonacci ratio, and (in the case of an up move) subtracting the result from the top of an up move. For example, the February 2016–September 2018 uptrend was around 1,131 points, low to high. Multiply 1,131 by 0.382 and you get 432 points, which, if you subtract from the September 21 high of 2,941, you get the 38.2% retracement level around 2509 shown on the chart. The implication is that level is a likely downside target, and also a point at which the market could bounce or rebound.

By the way, plenty of people attach no significance to Fibonacci ratios themselves, but some of them pay attention to Fibonacci retracement levels simply because they think other traders do believe they have significance, and will act on those beliefs.

So, it stands to reason that many traders may have noticed the 38.2% retracement level lining up just a tad below the February correction low.

Targets sometimes get hit, sometimes they don’t. The market sometimes rebounds off retracement levels, sometimes it doesn’t. But markets are made up of people, and it’s smart to be aware of what other people may think is significant

 

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1 StreetInsider.com. Home Depot (HD) PT Raised to $227 at Citi on 2Q Report; 'All-Around Strength...U.S. Macro Environment & Housing Market Remain Supportive'. 8/15/18./