How to Apply Fibonacci Analysis to Stocks and Options

11/05/2009 12:00 pm EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

It is my impression that while a significant number of commodity and forex traders use Fibonacci analysis as a regular part of their trading plan, many stock traders do not. If this is correct, I hope these articles will encourage more stock and option traders to use Fibonacci.

Many option educators concentrate only the option pricing, volatility, and of course, the various option strategies. I have heard some mention in passing that you should use technical analysis to find your trading candidates, but they rarely go into any detail as that is not the purpose of their presentation. I think applying Fibonacci projection analysis can be very useful if you are trading stocks, but even more valuable for option traders. This is because when you see a stock that is in a strong up or down trend, you can look for an interruption in this trend (continuation pattern) that you can use to determine both where the correction may end, as well as the trend's next targets. These targets can then be used by the trader to help select the strike price of the option and whether it is better from a risk perspective to trade the options or the stock.

So the first question might be how to select stocks for Fibonacci analysis. All you need is a stock that is in a good up or down trend, which can be determined as simply as searching for stocks that are up or down more that 35% in a six- to eight-week period. For this article, other than for the Apple chart below, I just went to Bigcharts.com and looked at the top sectors this year, then picked top performing liquid stocks from their list.


Figure 1 - Click to Enlarge

The stock I want to look at first is Apple (AAPL) since it has been a market leader for most of 2009. From the March 9 lows, AAPL rose from below $83 to over $135 by early May (point b). The first pullback lasted just five days, point b to c, and retraced less than 20% of the rally. The strong close at $130.78 on May 26, with 22 million shares trading, completed the correction. A rally equal to 50% of the rally from point a to b, and measuring up from point c gives a target at $144. This level also corresponds to the 161.8% retracement target using the correction from b to c (not labeled on the chart).

These targets were hit on June 5, point d, as APPL then turned lower and consolidated for five weeks, tracing out a flag formation. The continuation pattern was completed on July15 as AAPL gapped higher, closing at $146.88. The first upside targets were in the $152-$155 area, which corresponds to the 61.8% projection of the a-to-b rally and the 161.8% retracement of the d-to-e correction. More interesting targets were higher with the 50% projection of the rally from point a to d at $165, and then there was a cluster of targets in the $170-$172.50 area. This includes the 100% upside projection of the a-to-b rally, the 61.8% projection from the a-to-d rally, and the 261.8% retracement of the d-to-e decline. This grouping of targets might have had the option trader considering the 155 or 160 calls. AAPL hit a high of $172.49 on August 28, point 1, consolidated briefly before again moving higher. This had traders looking at the longer-term upside targets, ranging from $193 to $203. The most meaningful of these was the 161.8% projection of the a-to-b rally and the 100% projection from the a-to-d rally. AAPL's high so far has been at $208.71.

NEXT: Fibonacci Analysis of Alcoa (AA) and Expedia (EXPD)

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Figure 2 - Click to Enlarge

A stock in a completely different sector is Alcoa Inc (AA), which dropped below $5 on March 9 before beginning a dramatic rally. Fibonacci projections would not have been applied until the early-April peak at $9.39, or more likely after the reversal high, point b, on May 7. Using the a-to-b rally, the 38% support level was at $8.69 and the low at point c was $8.33, with the 50% support at $8.00, which could have been used as a guide for stop placement. Using the rally from point a to b and projecting up from point c gave us a 61.8% target at $12.10 and the high at point d was $12.38.

The ensuing correction was more significant, but it held just above the 50% retracement support of the rally from point a to d at $8.70 as the low at point e was $8.96. Given the low price of the stock, options may not have been considered. The 50%-61.8% projections using the rally from a to d were at $12.67 and $13.55, respectively. Alcoa's August high was $13.88 and the 100% projection from a to b, at $14.40, was hit in September. So far, AA is holding above the converging retracement support at $11.30 (I am hoping you know how we came up with these levels, but if not, look at Expedia below). One of the remaining upside projections is the 100% target using the rally from point a to d, which is at $16.50.


Figure 3 - Click to Enlarge

The travel and leisure sector has had outstanding performance this year, and Expedia Inc. (EXPE) was one of the leaders. Other than a four-day selloff in late April, EXPE moved from the March lows at $6.31 to the June highs at $17.65, point b, with little interruption. The six-week correction took EXPE to a low of $13.52, point c, which was above the 38.2% retracement support of the rally from point a to b. The 50% support level was at $12, so a stop at about $11.93 would have been reasonable.

The strong close above the short-term downtrend on July 13 suggested that the correction was over. EXPE gapped through the 50% upside projection from the a-to-b rally (not labeled on chart), leaving the 161.8% target from the b-to-c retracement at $20.33.The upside target was at $24.90 where the rally from c to d was equal to the rally from a to b. It exceeded in September, point d. The 261.8% retracement projection from b to c was at $24.50. Therefore, from the July 13 close at $15.82, the targets at $24.50-$25 could have helped option traders better develop a strategy. Expedia eventually made a high of $27.37 before dropping sharply, which allowed us to identify some key support levels. The major 38.2% support of the rally from a to e is at $19.40, while the 38.2% support from the c to e rally at $23.60 has been reached. The 50% support using the c to e rally is at $20.50.

MORE: Lesson Concludes with a Look at Massey Energy (MEE)

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Figure 4 - Click to Enlarge

Massey Energy Co (MEE) is a good example of how Fibonacci analysis can help us analyze non-classic chart formations. This stock was chosen because it was one of the top performing coal stocks this year. MEE formed a nice base in March and April, breaking out to the upside on April 29 on more than double the average volume. It quickly ran to a high of $23.79, point b, before correcting sharply. The correction just slightly exceeded the 38% support at $18.19, line 1, as the low was $17.68 (point c). MEE made new highs in June, point d, at $26.46 and just reached the 61.8% projection of the rally from point a to b. The correction from these highs was more complex as the first decline violated the previous lows, point c, which likely cleaned out many stops. The 61.8% support of the rally from point a to d did hold as prices stabilized for a few days before MEE again turned higher. From these lows, the upside targets converged nicely in the $32-$33 area. The 100% target using the rally from point a to b was at $32, while the 100% target using a to d was at $33. Both were projected from the low at point e and may have assisted option traders. Currently, MEE appears to be forming another complex continuation pattern as the 38.2% support of the a-to-g rally, line 2, has been reached. The 161.8% upside targets remaining are at $40.70 and $43.20.

I hope this article will be enough to encourage you to try applying this type of analysis to stocks or any of the other markets that you trade. As with many of the trading methods or indicators that I write about, it is critical for the individual to do their own research and testing since only then will you gain the necessary confidence to use it in your trading.

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