Stock prices never go straight up, or straight down, as the preceding charts show. They typically move in stair-step movements involving many small pullbacks to a trend line or moving average. These small pullbacks from the trend are known as “flags” and are bullish (bearish) if they occur in an uptrend (downtrend).
Note the numerous bull flags in Figure 7.13 that actually are pull-backs to a moving average, either the 20- or 50-day moving average. These short movements are minor price retracements, but a stock (and the overall market) occasionally makes a major price retracement, as well, as shown in Figure 7.12 and below.
Figure 7.13: RIMM Bull Flag Chart
Major retracements in price typically will be roughly 3/8, 1/2 or 5/8 of an uncorrected trend, though they can be lower, or even higher. These are scary, indeed, for the uninitiated, when they happen on an uptrending stock. Of course, falling stocks retrace, too, and the sudden strong rise in price often acts as a trap for unwary investors who then assume the worst is over.
Retracements – though we cannot predict exactly when they will occur or how severe or lengthy they will be – tend to conform to certain norms. Price tends to pullback (rise) to certain commonly-hit percentages of the previous uptrend (downtrend) – known as Fibonacci levels.
Figure 7.14: BHI – Bullish Retracement
BHI rose from a $41.81 low to a high of $61.90 over the course of four months in 2005, with only minor pull-backs.
In late September there ensued a major correction, known to technical analysts as a price retracement.
Figure 7.13 shows how the retracement fit into the Fibonacci levels that are most commonly hit: 38%, 50%, 62% and 70%.
In this case, BHI retraced well over 50% of its (relatively) uninterrupted price rise. Such a retracement is very common and is to be expected after a long and uncorrected run; and it actually is a healthy thing. Trending stocks have to prove themselves, and coming back from a major retracement does the trick. Baker Hughes, in fact, recovered and trended up to just pennies short of $90 months later. If this price action looks random to you, it isn’t.
Figure 7.15: ATI – Bearish Retracement
Note how this dynamic works in reverse on a stock in a downtrend, as shown in Figure 7.15. The small “bear flag” pullbacks on the stock’s decline eventually culminate in a retracement – a sharp price spike up in this case.
After price retraces just shy of 50% of the stock’s downtrend, price becomes briefly range-bound as shorts and longs fight for control.
Both Figures 7.14 and 7.15 illustrate how a stock, and the overall market, will after some period of rise or fall, make a decisive correction in the opposite direction. Experienced traders and investors expect retracements to occur. The reason for them is that a widely-held bullish or bearish outlook was responsible for the major trend. The longer the trend lasts, more and more true believers will become nervous… how much longer can this party last? At the same time, those with the opposite outlook will become increasingly emboldened that the stock has gone far enough.
At some point, the tide of bullishness or bearishness will run out of steam and the opposing forces control take the field.
Retracements, both major and minor (bull and bear flags in particular), should be expected and welcomed by canny covered call writers. They provide much-needed signposts for entry and exit points, not to mention some great opportunities.