Wednesday 12 June 2013

A little lesson

I sit and twiddle my thumbs. It does not come easily to me and it does not make for very exciting blog posts. I could just type in "nothing to report" over and over. Instead I thought I would  explain a bit about Fibonacci and Support and Resistance (S&R). I don't really hold with Fibonacci but S&R is at the core of the new timing system which is going to guide my entry and exit from the market from now on. Rather usefully the chart of the Dow Jones has provided excellent examples of both systems over the past few days.

Fibonacci 

I'm pinching a lot of this stuff from Wikipedia but I summarize. If you want more just follow this link and this one.

Fibonacci lived between 1170 and 1250 so it was a while before stock markets came into being. He was a
mathematician. He recognized how much easier it was to work with the Arabic numerals than it was with Roman ones. He was lucky not to have attracted the attention of the catholic church for if he had, I have no doubt he would have come to a sticky end. As it was he advocated the use of the numbers 0-9 and the extension of that sequence by the use of place values. He demonstrated how useful this was in bookkeeping and other types of accountancy. 

He also popularized a sequence of numbers that had first been described by Asian mathematicians and he gave that sequence his name. The sequence runs 1,2,3,5,8,13,21,34 and so on. You've already guessed how it works, each number is the sum of the previous two numbers. Fibonacci used it to predict population growth in an idealized rabbit colony.

What is amazing about the sequence is how often it appears in nature. The branches on trees, the leaves on a stem, petals on flowers, segments of a pine cone regularly develop in numbers that are found in the Fibonacci sequence. 

Another interesting characteristic is that the ratio between each pair of sequential numbers in the list converges to a ration known as the golden mean: approximately 61.8%. This ratio is widely used by artists and architects to create works of art and buildings exhibiting outstandingly fine proportions. The ratios between other numbers in the sequence also converge to  fixed values.



Stock market watchers, at a loss as to how to predict changes in direction in prices in the market, have adopted Fibonacci ratios to make their guesses as to when the market will turn.

On the chart of the DOW you will see that I used a Fibonacci sequence to predict, reasonably accurately the turn in the market from up to down. I drew a line between the latest high and the latest low. Helpfully my charting program calculated the Fibonacci ratios between the top and bottom of that price movement and, low and behold, when it got to that magic 61.8% the market stopped rising and began to fall. 

I have to confess that I'm not a true believer, but sometimes it works. And when you've got nothing else to help you, you might as well give it a go.

S&R

On the other hand I do believe in support and resistance. There are programs which generate S&R lines but mostly they pick up horizontal lines.which are based on previous highs and lows. Like the one I drew at 14869 which acted as a stop for that last fall in the market.



A series of diagonal lines, linking a combination of daily lows or closes marked the support of the market as it rose to its high point. When it then broke down a new support line, which started at the new low held the market up for five more days until it was broken on 31st May. By then a new resistance line had formed which kept the market on a downward path until it was broken just five days later. And now that resistance line has become a support line and has helped the market in its efforts to move higher again.

This development of S&R shows how we can interpret market movements from day to day. The S&R lines guide our thinking very effectively. As the price movement approaches a support or resistance line we can infer that a change of direction is likely as price action bounces off the line and returns to direction of the prevailing trend. If instead price action moves on through the line we can infer that the trend has changed.

At present we appear to have entered a period of market indecision with trends lasting just a few days at a time. By contrast the last uptrend continued, pretty much unbroken, for over 100 days. It was kept in play by a whole series of support lines. There were short periods when the trend hiccoughed, either because there was a small pullback, too unimportant to count as a downturn, or because the trend accelerated and a steeper support line needed to be drawn. 



The point is that these support and resistance lines can be drawn as they develop and they are valuable as guides to entering and exiting the market.

At present the message is stay out of the market and wait for a clear up signal before making any new investments.


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