Fibonacci factor

Figuring out the fallback

Over the years I have been tracking my trades, I have been sorely vexed by too many cases where I have bought on a pullback, only to discover later that the pullback wasn't over yet. It turns out I've been ignoring handy rules of thumb that students of the stock market have developed based on the Fibonacci sequence.

The Fibonacci sequence is a series of numbers formed by adding two starting numbers to make the next number in the series, continuing by always adding the two previous numbers: 1,2,3,5,8,13,21,34,55,89,144,.... Leonardo of Pisa, also known as Fibonacci, was a 12th century Italian mathematician who popularized this concept that had been described previously in India. It turns out that a Fibonacci sequence of numbers can be used to describe many observed phenomena in geometry, music, and nature. Some sharpie also noted that the sequence can be applied to how far a stock pulls back after a significant move upward.

According to John Murphy, a technical analysis guru, "Market corrections up or down usually retrace a significant portion of the previous trend. You can measure the corrections in an existing trend in simple percentages. A fifty percent retracement of a prior trend is most common. A minimum retracement is usually one-third of the prior trend. The maximum retracement is usually two-thirds. Fibonacci retracements of 38% and 62% are also worth watching. During a pullback in an uptrend, therefore, initial buy points are in the 33-38% retracement area.

Stockcharts.com, which I use for charting, even has a tool that draws the Fibonacci retracement lines on the chart and labels them. How convenient is that?

AVNR
AVNR stock chart overlaid with Fibonacci retracement lines

When I bought Avanir (AVNR) it had, indeed, pulled back to that 33-38% retracement area (see above), identified by Market Edge as a "good entry point." Except, somebody forgot to send AVNR the memo! It kept on going down, powering through the 50% level (supposedly the most common) and that magical 62% level as well.

I conclude that I have generally underestimated how far a stock will pull back before resuming its upward move. I've tended to jump in at the first sign of reversal, which often turns out to be a "false positive."

Applying the lesson

Accordingly, I applied this new insight (new to me, that is) today to two other stocks in my portfolio, in one case to take profits and in the other to limit losses.

LSCC

Lattice Semiconductor (LSCC) has been marching steadily upward from $5 to over $7.50. Yesterday was a volatile day, beginning down and trading way down, closing, however, near the open; volume was heavy. Today it tried to rally but failed. That's when I bailed out. If the Fibonacci pattern holds, LSCC could drop near my purchase price, or even below, with no guarantee of ever going back up again.

CYPB

Cypress Bioscience (CYPB) made a similar move from around $5.50 to $7.50, at which point it faltered. It pulled back below $7 and I jumped in, thinking the pullback was over. Yesterday's and today's trading, however, show that was probably a premature judgment. It is now back to that 38% level, and there is no obvious reason for it to stop. If I were to hang on to the 50% or even 62% level, I could suffer a sizeable loss, again with no guarantee of ever going back up again. Therefore, I bailed out to minimize the potential loss.

The watch list

Looking at my watch list, there are some obvious examples of stocks that I have been sorely tempted to buy. Considering what has happened with AVNR and CYPB, however, I think I'd better stay on the sidelines, at least as far as these stocks are concerned.

BIVN

Bioenvision (BIVN) has jumped from $4 to nearly $6.50 then pulled back to $5.50, the magic 38% number. Conventional wisdom says that would be a good entry point, but I think I'll wait to see whether it goes on to test the 50% level, or even the 62% level. If the Fibonacci pattern holds, I should be able to get this stock at $5.25 or even $5.

SLXP

Salix Pharmaceuticals (SLXP) is still going up from the starting point around $9.75. I almost bought last week when it fell back to $12.50, but now I'm thinking that a buy at $12 is more reasonable, and $11.50 is not out of the question.

TIBX

TIBCO broke out of a triangle formation formed by tests of the $8 level. That would, of course, have been the ideal point to jump in. But I didn't. Now I suspect that the best thing would be to wait for the correction.