In early October, the stock market took a nose dive and a steep pullback in equity prices ensued. Nearly a month later, we are by and large not only back at price levels that preceded the selloff, but in some stock indexes, we have witnessed new highs.
Two tech stocks that have surpassed their prior peaks for the year include Microsoft Corp. (NASDAQ: MSFT) and Yahoo Inc. (NASDAQ: YHOO). With these stocks serving as case study examples, in this analysis we are going to highlight the Fibonacci extension tool as a technical approach to identifying possible upside price targets after a stock sells off and subsequently holds support to recover its prior peak and continue a new wave higher.
For those not familiar with Fibonacci, we highly recommend reading this detailed introduction on Investopedia. Essentially, the quotient derived from adjacent numbers in the Fibonacci numerical sequence, roughly 1.618, is known as the golden ratio. It is occurring in nature and as we will see in this post, it has some applicability in the markets to projecting stock prices as well.
MSFT vs. YHOO: Upside Price Target Projections
$MSFT : Microsoft Corp. ; $YHOO : Yahoo Inc.
Let's begin with MSFT: As we can see from the daily chart above, the stock hit a high of $47.57 on 9/19, noted by the red arrow. In the October market selloff, MSFT retraced to a low of $42.10 by 10/15. Notice to the far left of the chart that the $42 area had been a previous congestion zone; it was confirmed as support, with buyers arriving to bring the price pullback to an end.
The bulls recovered the entire selloff and overcame the previous $47.57 high by 11/5, when MSFT closed at $47.86. The bulls have continued the move higher since, with the stock closing at $48.68 on 11/7. The question must then be asked: what price on the upside could MSFT hit?
Using Fibonacci extension, since MSFT bulls were able to reclaim 9/19 high and have now surpassed it, we can calculate the 1.618 Fibonacci price target at which we could expect the move higher from the 10/15 low to pause; as noted, the price target would be $50.95:
$47.57 (9/19 high) minus $42.10 (10/15 low) = $5.47
$5.47 multiplied by 1.618 (golden ratio) = $8.85
$8.85 added to $42.10 (10/15 low) = $50.95 (intermediate price target)
Note that the price target may or may not be hit. It is simply calculated as a reference point at which traders can probably expect selling pressure to start to exceed buying interest, in the event that the stock actually reaches that price level.
Now let's look at YHOO: The stock previously peaked at $44.01 on 9/15, noted by the red arrow. In the October selloff, the stock retraced to a low of $36.20 by 10/15. Again, as highlighted on the far left of the chart, the $36 level had been a previous congestion zone; it was confirmed as support and buyers provided a cushion of relief to end the selling at this point.
The bulls recovered the entire pullback and overcame the previous $44.01 high by 10/27, when YHOO closed at $44.70. The bulls have continued to push the stock higher, with YHOO closing at $48.55 on 11/7.
Using Fibnoacci extension, since YHOO bulls were able to reclaim the 9/15 high and have since exceeded it, the 1.618 Fibonacci price target for the move higher from the 10/15 low would be $48.84. Interestingly, we've pretty much reached it! Here's how we calculated it:
$44.01 (9/15 high) minus $36.20 (10/15 low) = $7.81
$7.81 multiplied by 1.618 (golden ratio) = $12.64
$12.64 added to $36.20 (10/15 low) = $48.84 (price target nearly reached)
Unlike MSFT, YHOO has essentially attained its 1.618 Fibonacci extension price target and thus provides validation for using this technical approach in trade planning. We may thus expect to see some selling pressure build up now that the price target has been reached.
Conclusion
Fibonacci extensions are most useful when applied with other technical indicators in analyzing trending moves. In the examples above, we emphasized the 1.618 Fibonacci price target; however, an additional level we may come across is the 2.618 price target, although this is not commonly seen as applied to a single wave of a price move higher.
When determining the high and low price levels of a prior wave to calculate the next bullish wave's Fibonacci extension targets, most trading platforms require entering three price levels:
Price Level 1: Low Price
Price Level 2: High Price
Price Level 3: Low Price
In this analysis, since the troughs for both MSFT and YHOO were prior congestion zones on their charts, the individual lows for each security as entered into our trading software to calculate the Fibonacci extensions were equivalent.
As the example of YHOO has shown us, the Fibonacci extension method offers traders the ability to estimate price targets after selloff recoveries. It's a commonly used approach to projecting prices and anticipating where profit taking may occur in a subsequent price move higher. Although it is not an exact science, it is still helpful as a trading tool, keeping in mind that no single method to evaluating the market is bullet proof and trading success ultimately boils down to managing risk versus reward.