February 2000

Leonardo de Pisa de Fibonacci (born around 1170 in Pisa, Italy) was a mathematician who studied the Great Pyramid at Giza and discovered a number series which we now call Fibonacci numbers.  The number in the series is the sum of the two previous numbers, and includes the set 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, and 144.   Dividing one number by the next after the 8th sequence yields 0.618, which happens to be the relationship of the height of the Great Pyramid to its base.  Another relationship is that the next number in the sequence is approximately 1.618 times the preceding number.   These relationships are also a Fibonacci number series: 0.382, 0.618, 1.000, 1.618, and 2.618, etc.

Fibonacci numbers are valuable because these numbers and relationships are found everywhere in nature and in the markets.   Frequently the magnitude of a wave will have a Fibonacci relationship to the magnitude of another wave structure.   A wave's magnitude is determined by measuring the price range from a significant top to a significant bottom.  The magnitude of a Trend wave might be 1.618 times the magnitude of the previous Retracement wave.  A corrective Retracement wave might be 0.618 times the magnitude of the previous Trend.

Larry Pesavento shows in his book 'Profitable Patterns for Stock Trading'  that two additional ratios are frequently found in the markets.  These ratios are the square roots of the two primary Fibonacci ratios.  The square root of 0.618 = 0.786, and the square root of 1.618 = 1.272.   Larry uses these two additional relationships, 0.786 and 1.272, because not all waves are a ratio of 0.618 and 1.618, or the other common ratios of 0.382, 0.500, and 2.618. 

This example daily chart, Lucent Technologies Inc. (LU), is loaded with Fibonacci relationships.   The number of bars in each trend is shown in a red box.   Note that the number of bars in the initial trend and its narrowing triangle consolidation sum to a Fibonacci number 55 = 8 + 8 + 5 + 8 + 5 + 8 + 8 + 5.   Note the three wave bottoms that occur on the 13th bar cycle from the prior bottom.  Note the break away gap and the 21 bar run to the 1.618 Fibonacci extension level top.

Fibonacci ratios are easily applied to a chart using the Fibonacci Levels tool in Ensign Windows.  When you click on the  Fibonacci Levels button, the cursor will change to a pencil while in the draw mode.  A start and end point are necessary to draw Fibonacci Levels on a chart.  The distance between the start and end points is divided into Fibonacci Levels which suggest possible support and resistance points.  To draw Fibonacci Levels on a chart move the cursor on the chart to the starting point.  The starting point is generally an important high or low on the chart.  Click the left mouse button down and drag the mouse to the ending point, and release the mouse button.  The ending point is usually the end of an important trend or correction following the starting point.  Watch for the completion of a trend or correction at a Fibonacci Level.

After drawing Fibonacci lines on a chart, click the right mouse button to display the tool's properties window.  The properties window is used to change the levels, color, style, and defaults.  A check box list of common ratios is provided so that specific levels can be displayed or hidden.  The list includes the levels 0.786 and 1.272 that are the focus of this month's study insight.

'Profitable Patterns for Stock Trading' , by Larry Pesavento, Copyright 1999, published by Traders Press, Inc., ISBN# 0-934380-47-3

Perhaps it is just an inherent human trait, but it never ceases to amaze me the eagerness with which we want to embrace someone else's opinion.  What worries me is when traders don't think for themselves and place too much trust in supposed 'experts'.  That characteristic is even manifest by some who subscribed to this newsletter hoping it would tell them what to buy or sell.  This newsletter won't do that.  Instead it will try to teach you to think, and give you tools and insight to help you do your own technical analysis.

One can find on the Internet countless web sites offering advice, newsletters, and stock picks.  I raise a warning voice that traders should not be so eager to embrace the information they peddle.  I offer the following look behind the smoke screen.

Many of the newsletters which offer daily picks, or hot-stocks to watch, fall in the category which I call 'pump and dump' services.  They artificially manipulate stock prices for the benefit of the owners of the service.  Some of the picked stocks pay the newsletter or brokerage for the promotion.   Several years ago my broker would call with suggested stocks to buy.  I remember investing in Ramada Inns around $11 on the broker's recommendation.   His firm's research department had issued a buy recommendation for Ramada.   The stock ended up being near its peak when I bought, and I eventually exited around $7.   Where was the broker during the decline?   It sure felt like I had been a victim of a 'pump and dump' promotion so my broker's firm could unload Ramada stock, or he could turn a commission.

One of the stock-pick web sites I visited bragged that 83% of their picks hit their suggested target price.  I looked at their stock picks for the month of December, and their table showed an impressive 20 out of 20 picks with a positive value in the column labeled 'The Point Move It Made So Far'.   So, I looked at daily charts for each of their 20 stock picks for December, and marked the price and the day of the suggested pick.   In so doing, I then saw through the smoke screen and got an immediate distaste in my mouth for this stock-pick service.   Look at the following example that was their stock pick on 12-02-1999 at a price of $18 1/4.

The following irritates me.   First of all, this service says their entry price is $18 1/4.  This is the closing price on December 1st and is pointed to with a red arrow.   The stock pick was supposedly in an e-mail issued on December 2nd prior to the market opening.   If one acted promptly, one might have bought the December 2nd open, but that is at a higher price than the $18 1/4 they imply their subscribers bought at based on their pick recommendation.

The real irritation is that they say this stock has made a $2 7/16 move so far.   When you study the chart, $2 7/16 is the difference between the pick price of $18 1/4 and the highest high following the pick, which just happens to be on December 2nd, the day of the pick.   One would have had to buy the previous day's close (impossible to do on December 2nd), and sell at the highest high since then in order to realize the results implied by this service.   Come on people, give me a break.   That isn't going to happen.   The implied 13% gain on this recommendation is in reality probably a 30% loss.   In all fairness, some of their December picks have good gains after 4 to 8 weeks.   What I am trying to illustrate is that there is no substitute for doing your own thinking.

A second Internet stock-pick service I found, on the surface looked exciting.  This service evaluates 7,000 stocks each day and rank orders them according to scores given for value, safety, and timing.   To monitor their stock picks, I entered their top 50 buy recommendations in a paper trading account and used the closing price on January 25th as the entry price.   I dollar balanced the portfolio to invest $5000 to $6000 in each stock.   Was it just my 'bad luck' to start this exercise before the DOW had a down week because of fear interest rates would rise?

Anyway, one week later the account was down 4.7%.   But, during the same time period, the DOW fell 2.6%.  So, what gives?  One would not expect a list of BUY recommendations to crash faster than the DOW.  In fairness to this stock-pick service, they expect you to invest for the long haul, and my critique of one week's setback is probably unfair.

Whether I am right or wrong in my assessment, or whether either of these stock-pick services are worth the monthly fee they charge is not the issue.   What I am trying to do is to get you to think.   Be suspicious of stock-pick recommendations.  Do your own analysis and thinking.  The greatest value I personally find in these stock-pick services is it causes me to look at charts I otherwise would not have examined.   Occasionally, I find a recommended stock with a chart formation that is attractive to me.   Usually the biggest problem is that by the time the stock appears on a recommendation list, the move I am interested in is already history, and the chart is about to enter a consolidation or correction wave.

ES:  How long have you been trading, and what software do you use?

AC:  I have been trading for more than 20 years.   Years ago when I was a large potato farmer, I traded Ag products during the winter months.  Now that I no longer have the farm, I am a full-time S&P day trader.   I have used Ensign Software programs since 1984.

ES:  Which markets do you trade?

AC:  I day trade just the S&P.   4 or 5 times a year I might make a position trade in an Ag market.   I would consider positions in wheat, soybeans, cotton, sugar, heating oil, orange juice, US bonds, live cattle, feeder cattle, live hogs, and pork bellies.

ES:  What chart time-frames do you use?

AC:  I watch a 3-minute chart and a daily chart for the S&P.  I don't look at anything else.

ES:  What studies and tools do you use?

AC:  None.  I know you didn't want to hear that answer.   I pay attention to the bar formations on the 3-minute chart, and have developed a sense or gut feel of how the market will behave.   Yesterday was a huge down day, and my gut feel a couple hours into today's trading was that the bottom for today had been put in, and a sizable rally of 2000 to 3000 points would occur before the close.   I watch for support and resistance levels and try to safely enter the market in the direction of the trend.

ES:  How frequently do you trade?

AC:  I trade 4 to 10 times a week.  I am patient and wait for the market to establish a trend.  If the trend is up, I try to board the trend using stops above resistance, or buy a setback.  When the trend is down, I will sell short using stops below support, or sell a rally.  But my trading is always in the direction of the trend.  I never keep an S&P position overnight.

ES:  What kind of market do you look for?

AC:  One or two days a week, the market fits my style.  I stand aside in fast markets because they can't guarantee fills and it is hard to know if one is in or out of a fast market.  Presently, these dynamic markets are historic in their volatility.   Markets like these have never existed before, so I don't think there is a system out there that has the experience to deal with today's markets.  Even prior experience may not be sufficient.  I am constantly learning and adapting to the market as it evolves.

ES:  Since you don't use any of Ensign 6's studies or draw tools, what do you look for in a chart?

AC:  I watch price congestion levels, flags, pennants, breakouts and retracements.  I watch highs and lows, where the market closed the day before and where it opened today.  I wait for the market to establish a trend and try to board using stops, or buy setbacks and sell rallies.

ES:  What about risk management?

AC:  When I place an order, my broker sends the order to the floor, and then while the broker is still on the phone, I place a protective stop.   I never hang up with my broker without a stop in place.  Years ago there was a time when my broker's phone quit working, and there have been times when a news event moved the market and one won't know about it in time.  For example, I was long the S&P the day the Challenger exploded.  I always place a protective stop while I am on the phone with my broker.  Then I am not in a panic if the market turns on me and does something unexpected.

ES:  What do you look for in a broker?

AC:  The primary factor I need is best execution.   That is more important to me than the commission.   The way I trade, I am often in the market for only 10 to 15 minutes.  My broker has a flash line to the floor.   I basically quit trading the Ag products because their opportunities come only 4 to 5 times a year.  But with the S&P's volatility, there is opportunity every day.  For my style of day trading, I need quick execution.

ES:  What is the ideal trade for you?

AC:  The perfect trade is a small move with a large position in a highly predictable formation.   The money I take out of the market is a small move in a short period of time, but with a large position.  (ES:  AC gave more details but wanted the specifics withheld.)  I really don't like to suffer a lot.  I am quick to be in and out of the market.  If the market does not do what I expect immediately, then I get out of the trade.

ES:  What advice would you share with the readers of the newsletter?

AC:  Don't trade bigger positions than you are ready for.  You need to get your trading style worked out first.  Too often traders have a few successes, and then get their head handed to them on a plate.  I work very hard at not having any preconceived ideas about where the market will go.  Last of all, you have to do the work yourself.  I remember years ago being in a pork belly spread at my broker's advice before a report.  The broker said the spread was a safe way to play the report.   The day of the report, each leg of the spread went limit against me.   If you want advice from a broker, you should consider why he is a broker instead of a trader.  You just have to do your own work.  Trading today's markets is a technologically based art.