Trading Stocks with Fibonacci and Lucas

Article excerpt

For many traders, only time-proven strategies will do. Two techniques that have proven themselves through decades are Fibonacci analysis and the Lucas Time Series. But key to using them effectively in individual stocks and the broader market is to know when they're validated.

Navigating a correction is similar to flying through a storm cloud. Everyone on board has confidence they'll get through it, even if they have no idea how it will happen. In complex corrections, most traders are like the passengers on that plane. They know the correction will eventually end even though they have no idea when it will happen.

The time element of technical analysis works the same way as the instrument approach that a seasoned pilot uses to land a plane in zero visibility. "Finding patterns with the Lucas Time Series" (September 2006) highlighted how the time dimension can be used as a pattern recognition system. Here, we will look at ways to navigate through a correction until market direction becomes clear again.

Corrections in all financial markets offer unique challenges. To the trend follower, a whipsaw that depletes the bankroll isn't a distinct possibility; it's a fact of life. A momentum player has to decide where to bail out in the event a pullback retraces into the prior trend.

One discipline uses moving averages while another depends on common Fibonacci retracements. The dilemma is that price action can spike beyond the moving average or Fibonacci point, taking the stop and leaving the trader on the sidelines. Traders also use different moving averages. Which retracement or moving average dominates is a constant challenge even to the experienced trader. Price action usually lands near a cluster of common Fibonacci points or between a set of moving averages.

The other challenge in recognizing corrections is whether they will be what Elliotticians call a sharp or flat pattern. A sharp correction will move counter to the main trend and will generally retrace 38%, 50%, 61% or 78% of the main trend. The problem with sharp corrections is the difficulty in determining which one of these levels will end the pullback.

A flat correction will take on the shape of a sideways consolidation and sometimes turn into a triangle. The challenge for traders when working with sideways consolidations is they seldom retrace beyond 38% and sometimes only 23%. Moves that retrace between 23% and 38% are fairly simple to recognize, but the trick is knowing when they will end.

UNDERSTANDING CORRECTIONS

All markets cycle according to Fibonacci price and time movements. Of course, it's not perfect; the Fibonacci time sequence works about 60% to 70% of the time. However, when it doesn't work, the Lucas series fills most of the gap. Most traders who have become familiar with the Fibonacci time dimension are only now becoming aware of how often the Lucas series reveals itself in the markets.

Three case studies demonstrate this condition with different degrees of complexity.

Exchange-traded funds (ETFs) have become popular for traders and investors who want to play a certain sector of the market without having to rely on any particular stock.

"Crazy like a Vox" (right) is a daily chart of the Vanguard Telecommunications Services (VOX) ETF, which represents the telecom industry. This example highlights both challenges for traders even though it is a fairly common pattern. The first problem is to determine if the correction will be deep or wide. In real time the pattern develops into a complex sideways wave that is tricky to play.

Fibonacci retracements can guide the trader in determining the depth of the pullback. When drawing retracement lines, the challenge is determining which major pivot is going to dominate. The solution is simple: Draw retracements from both pivots.

There are two major pivots in this example, one on Oct. 19, 2005, and the other on Jan. 3, 2006. …