Explore the Forecast SR Levels

Learning to Forecast SR Levels

Can we forecast SR levels? Many technical methods offer an objective or target on the completion of a particular pattern or technique. You can think of these targets as forecasted SR levels. In this section, we review chart pattern targets, ratio analysis, and the Elliott Wave technique.

Chart Pattern Measured Movements

In the head and shoulders pattern (Figure 6-1), prediction is possible because the pattern itself is such a strong indicator. By measuring the difference between the neckline and the head (A-B) and anticipating that the price will move through the neckline, we can anticipate that the price will fall at least as far below the neckline (B-C) as the difference between the top of the head to the neckline. This symmetrical offsetting pattern is a popular technique used by many chartists. The expectation in a head and shoulders bottom is the same. If the neckline is violated, the market should rise an equal distance above the neckline as the difference

Figure 6-1

between the head and the neckline. This price area then becomes a target. In addition, when the neckline is first penetrated, prices may retest the neckline (Point D) before continuing the new trend. Typically, the volume during the retracement is low, implying a counter trend movement.

The double and triple top or bottom patterns are subject to the same price patterns. For the double (Figure 6-2) or triple top, the difference between the extreme price of the pattern and the support points occurring between the price peaks (A-B) is the starting point for anticipating a price target. When the support point gives way, this difference is subtracted from the support level (B-C), and that becomes the target within this pattern. Increased volume with a weakening support level indicates that sellers are picking up momentum.

Figure 6-2

The double or triple bottom objective is the difference between the extreme low and the resistance level formed between the low points. If the market trades through the resistance level then the difference is added to the resistance level, to identify the new target or next resistance level.

Larger triangles, which form over several weeks or even months, have a measured target. Targets can be set for symmetrical, ascending, and descending triangles with the same technique. The widest vertical range in the triangle is added to the apex for an upside breakout or subtracted from the apex for a downside breakout. For example, in Figure 6-3, subtract the difference between points A and B and then add this difference to the apex (C to D).

For short-term triangle and flag formations, the same techniques are used to identify an initial

Figure 6-3

target. However, as shown in Figures 4-8 and 4-9 (see Chapter 4), short term flags and triangles may develop quickly, so using a trailing stop rather than a target price could be more profitable.

Traders may identify targets based on chart patterns, especially reversal patterns, as a first objective in the trend. Therefore, many traders take partial profits when the target is hit, and then move their stop loss point to the initial entry price. If the market reverses, profits are locked in on a part of the position and are at breakeven on the remainder. If the market continues the trend, a trailing stop can be used to exit the remainder of the position.

Ratio Analysis

Technicians use ratios to calculate future SR levels. The most common approach looks for a 50%

Figure 6-4

retracement of the previous swing. For example, Figure 6-4 shows two cases, one for an up trend and one for a downtrend. The counter trend movement is expected to retrace 50% of the previous swing from points A to B, and then to C.

A method identified by one trader is called the "Rule of Seven," a formula used to set price objectives.1 First, calculate the difference between the high and the low of the initial upswing, multiply the difference by seven, divide the product by four, and add that to the low for the first objective. For the second objective repeat the steps but divide by three, and for the third objective divide by two.

Here are the formulas:

Upside objective #1: High minus low, multiply by 1.75, add to low price.

Upside objective #2: High minus low, multiply by 2.33, add to low price.

Upside objective #3: High minus low, multiply by 3.50, add to low price.

Downside objectives use 5, 4 and 3 for the divisor:

Downside objective #1: High minus low, multiply by 1.40, subtract from the high price.

Downside objective #2: High minus low, multiply by 1.75, subtract from the high price.

Downside objective #3: High minus low, multiply by 2.33, subtract from the high price.

These objectives can be applied to either swing measurements or for confirmation of classic chart pattern objectives. Figure 6-5 is a weekly chart of figure 6-5  Boeing. Points A to B is the first leg up from the

Figure 6-5

bottom where the high has a lower high preceding and following it, and the low has a higher low preceding and following it. The difference in price is $38.9375 - $32 = $6.9375. Therefore, by applying the Rule of Seven to project the targets, objective 1 is $32 + (1.75 x $6.9375) = $44.14; upside objective 2 is $32 + (2.33 x $6.9375) = $48.16, upside objective 3 is $32 + (3.50 x $6.9375) = $56.28.

Figure 6-6 is an example of the Rule of Seven for downside objectives from a top using a weekly chart of Boeing. Swing A to B is $70.9375 - $54.56 = $16.38. Objective 1 is $70.9375 - (1.40 x $16.38) = $48.00 Objective 2 is $70.9375 - (1.75 x $16.38) = $42.28; Objective 3 is

$70.9375 - (2.33 x $16.38) = $32.78.   

Figure 6-6

Fibonacci Targets

Technicians also employ ratios derived from a mathematical phenomenon called the Fibonacci series. This series is a sum of the previous two numbers (0, 1, 1, 2, 3, 5, 8, 13, 21 . . .). If you calculate the ratios of two numbers in a series you will note the progression is 100%, 50%, 66%, 62.5%, 61.5% . . . 61.8%. Calculating the difference between 100% and 61.8% is 38.2%. The Fibonacci series is considered the basis for naturally occurring change. Technicians have developed many elaborate uses of the ratios. One of the most complex is the Elliott Wave.

Elliott Wave

The Elliott Wave up trend consists of five waves or swings (Figure 6-7). Waves 1, 3 and 5 are considered impulse (trend) and waves 2 and 4 are corrective

Figure 6-7

 (counter trend) waves. Wave 1 peaks, with resistance at the top of wave 1, and wave 2 corrects wave 1. Wave 2 can be expected to retrace anywhere from 38.2 to 61.8% of wave 1, and sometimes back to the origin point. If wave 2 retraces all of wave 1, a double bottom is formed.

As the peak of wave 1 is surpassed, resistance may give way, and the price would then accelerate. This is typical after resistance level breakout. Wave 3 is often the longest of the waves. Followers of the Elliott Wave often project that wave 3 will complete a new higher level for resistance, which would then form a Fibonacci expansion of wave 1, such as 138.2% to 261.8% of wave 1 (Figure 6-8).

The peak of wave 3 establishes a new level of resistance, and wave 4 corrects wave 3. Wave 4 establishes a new support level. Wave 4 is expected to unfold in some manner different from

Figure 6-8

the characteristic of wave 2. For example, if wave 2 was deep, retracing 61.8% of wave 1, then wave 4 may be shallow and only retrace 38.2% of wave 3.

Wave 4 should be expected to retrace back to the support level formed when wave 3 completed its internal wave 4 level. Wave 4 is complete and wave 5 breaks through the resistance level (wave 3's peak). The peak of wave 5 will form a new resistance level. Elliott Wave technicians will project wave 5 peak to be a ratio related to the height of wave 3, or from the height of the beginning of wave 1 to the peak of wave 3.

SR levels are significant factors in computations and projections under the Elliott Wave technique, invariably based upon the relationships explained under the Fibonacci ratio relationships.

Summary

Patterns emerge in prices that can be useful for making informed target projections. Assuming that price patterns are themselves dependable, the methods developed by technicians can be used as first signs of an emerging target, or as confirmation for more familiar patterns, such as head and shoulders patterns or strong testing of SR levels.

As much intelligence as you gather from this study of price, it is only one aspect of the larger question. You improve your analytical skills with the combined study of price and volume trends. This idea is the topic of the next chapter.