In the previous video, we learned about bull
traps, or temporary rallies that can appear
during a downtrend, luring overly-optimistic
traders back to the market, only to frustrate
them when the downtrend returns.
So how do you know if you’re looking at
a potential bull trap?
Some traders use a technical tool called the
"Fibonacci Retracement Trend” line. Markets
tend not to move straight up or down; instead
they often “retrace” a portion of their
last move before a trend reasserts itself.
Those retracements often occur in ratios first
established by a 13th century mathematician
named Leonardo de Pisa, nicknamed Fibonacci.
You can create Fibonacci retracement lines
by choosing a major peak and trough on a stock
chart. The tool creates horizontal lines at
key Fibonacci ratios--23.6%, 38.2%, 50%, and
61.8% of the distance between the peak and
the trough. You can then use these lines to
identify possible support and resistance levels.
Let’s look at a key example using the S&P
500 index. We’re looking specifically at
the period between October 11, 2007 and October
2008 to highlight the peak-to-trough move.
Here we see that the price touches matching
lows about two and a half weeks apart, which
some traders see as a signal that the short-term
bottom may have been reached and might not
be retested again.
However, by overlaying the Fibonacci retracement
tool on the price action, we can see that
the price encountered resistance at the 23.6%
level after the second bounce.
Savvy traders might wait for the price to
break through this level and hold for a day
or two before entering a position. If we take
the chart forward, we can see how their patience
would have been rewarded: Had a trader chosen
to start a new position on November 4th, 2008,
they’d have been forced to wait until August
of 2009 before that purchase was profitable.
Because what happened next? The S&P 500 hit
a new short-term bottom near $740. A new bottom
calls for a re-drawing of the Fibonacci retracement
levels. The bounce off this $740 level rallied
again into the 23.6% retracement level before
retreating lower, eventually marking the absolute
bottom in March 2009. It eventually retraced,
and held, the 23.6% level before establishing
a new short-term uptrend. We can then add
the 50-day simple moving average to confirm
that upward move. So in this example, using
Fibonacci retracement levels and then moving
averages could have helped to identify a bull
trap in late 2008 and a buying opportunity
in early 2009.
Of course, this isn’t to imply that Fibonacci
tools are infallible. As with any technical
tool, the goal is for traders to test convictions
and then appropriately set their risk levels.
Make sure to watch our other videos on technical
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