Back to Basics – How far a corrective move is likely to go

With several markets showing signs of corrective activity this week ahead of the Fed (gold, EUR/USD, S&P). I want to take a stab at answering that thorny question of how far a market is likely to correct. I am going to use the EUR/USD daily chart for my analysis. First thing I do is note where any trend lines are and ask are they vulnerable? If they are, I then ask what level needs to break in order for the correction to get underway in earnest. For EUR/USD that would be 1.08/1.0775 (location of the uptrend, 20-day m.a., the May peak and the March low). I then apply Fibonacci retracements; this could be one retracement, or it could be several.

So how do I decide where to attach the Fibo’s.

Let’s take a look at the recent up move on the daily EUR/USD chart. There will be several ways to do this and no one way is right or wrong. But as a rule of thumb, I like to go from the lowest point of the move to the highest point of the move, unless we have a secondary low that is more than a 78.6% retracement of the first low and it is clear that the move started from there. For today I am going to use the .9536 low charted in September. I am also going to apply a Fibonacci retracement from the .9730 November low. Why from that point? Because if you look at the chart you can see that the up move started to accelerate from that point.

I then look for convergences.

So, we have two Fibonacci retracements – next thing I look at is are there any convergences? On this chart not really, but the 50% and 61.8% retracements are close enough at 1.0191/10230. We also find the 1.0198 September high there as well. So that should act as the floor for any correction down. Just ahead of here lies the 200-day m.a. at 1.0311, and realistically I would like this to hold for a nice healthy up move to remain in place. What happens if this area does not hold? It could suggest that the market is starting to weaken once more, that the up move is weakening… you have to become hyper vigilant.

So how do we determine which Fibo is likely to hold?

I like to use the daily RSI, I tend to use a 9 period indicator. If you read any textbook on the RSI, they will tell you below 30 is oversold, above 70 is overbought. I say – ignore that – look only for clear divergences to determine oversold and overbought, and also work out from the indicator itself where the support and resistance is – so for EUR/USD that is currently 76 on the topside and 18.65 on the downside (see red lines on the RSI). When the oscillator gets down to 20/18 – whatever Fibonacci retracement is in that vicinity is likely to hold.

Bet you thought technical analysts just guessed (too funny!!), well we don’t!

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