Schiffs Law

Schiffs Law

Schiff's Law is a financial concept, primarily used in the context of Commodity Markets and Technical Analysis, that suggests a predictable pattern in the price behavior of commodities following a significant peak or trough. Developed by Donald R. Schiff, a renowned commodities trader and author, the law posits that a commodity price will typically retrace a significant portion of its initial move – usually between two-thirds and three-quarters – before establishing a new trend. While not a rigid rule, Schiff's Law provides a valuable framework for understanding potential price reversals and identifying possible trading opportunities. This article will delve into the intricacies of Schiff's Law, its historical context, practical applications, limitations, and how it relates to other Trading Strategies.

Historical Context and Origins

Donald R. Schiff, the originator of this principle, spent decades trading commodities, particularly precious metals. Through meticulous observation of price charts and market behavior, he noticed a recurring pattern: after substantial price movements in either direction, commodities tended to retrace a large percentage of that move before finding sustained support or resistance. He formalized this observation into what became known as Schiff's Law. Schiff’s work, documented in his book "How an Ordinary Person Can Beat the Pro at Investing," emphasizes the importance of understanding market cycles and recognizing potential reversion to the mean. He argued that emotional extremes often drive prices beyond sustainable levels, inevitably leading to a correction.

It's important to note that Schiff's Law isn't based on complex mathematical formulas or econometric models. It's an empirical observation derived from analyzing historical price data. Therefore, it’s considered a heuristic – a rule of thumb – rather than a deterministic law. Its effectiveness relies on recognizing the underlying psychological factors driving market behavior, such as fear and greed, which often contribute to overbought or oversold conditions. The law gained traction within trading communities as traders began to corroborate Schiff’s observations in their own analysis of various commodity markets, including Gold, Silver, Crude Oil, and agricultural products.

The Core Principle: Retracement Percentage

The central tenet of Schiff’s Law is the expectation of a significant retracement. Specifically, the law suggests that the price of a commodity will typically retrace between 66% and 75% of its preceding move.

Let’s illustrate this with an example:

Imagine a commodity that rises from $10 to $30, representing a $20 increase. According to Schiff's Law, a likely retracement would be between 66% and 75% of that $20 gain.

**66% Retracement:** $20 * 0.66 = $13.20. The price might retrace to $30 - $13.20 = $16.80
**75% Retracement:** $20 * 0.75 = $15. The price might retrace to $30 - $15 = $15.00

Therefore, Schiff’s Law would suggest looking for potential support levels around $15.00 to $16.80. Conversely, if the commodity were to decline from $30 to $10, a similar principle would apply to the retracement upwards.

This retracement isn't necessarily a clean, single movement. It can involve multiple swings and consolidations within the expected range. The key is to recognize the *potential* for a retracement to occur within the specified percentage. Traders often use Fibonacci retracement levels, alongside Schiff's Law, to identify potential support and resistance zones during these retracements. The 61.8% and 78.6% Fibonacci levels often align closely with the 66%-75% range suggested by Schiff.

Practical Applications in Trading

Schiff’s Law can be applied in several ways to inform trading decisions. Here's a breakdown of common applications:

**Identifying Potential Entry Points:** The retracement phase, as predicted by Schiff’s Law, can provide attractive entry points for traders looking to join the prevailing trend. For example, after a strong uptrend, a retracement to the 66%-75% level might present a buying opportunity, anticipating a resumption of the upward move.
**Setting Profit Targets:** Understanding the potential retracement can help traders set realistic profit targets. If a commodity is expected to retrace significantly before continuing its trend, traders might adjust their profit targets accordingly, allowing for a larger overall gain.
**Placing Stop-Loss Orders:** The retracement levels can also be used to strategically place stop-loss orders. A stop-loss order placed below the expected retracement range can help limit potential losses if the trend reverses unexpectedly. Using Average True Range (ATR) can help refine stop-loss placement based on market volatility.
**Confirming Trend Strength:** The depth of the retracement can provide clues about the strength of the underlying trend. A shallow retracement (e.g., closer to 66%) might suggest a stronger, more sustained trend, while a deeper retracement (e.g., closer to 75%) could indicate a weaker trend or a potential trend reversal.
**Combining with Other Indicators:** Schiff’s Law is most effective when used in conjunction with other Technical Indicators. For instance, combining it with Relative Strength Index (RSI) can help identify overbought or oversold conditions that might signal the start of a retracement. Similarly, using Moving Averages can help confirm the direction of the trend and identify potential support and resistance levels. MACD can also provide confirmation signals.

Examples in Recent Market History

Let’s examine a few historical examples to illustrate Schiff’s Law in action:

**Gold (2020-2022):** Following the initial surge in gold prices during the COVID-19 pandemic in 2020, peaking above $2070 in August, the price retraced significantly. The price fell to around $1680 in March 2021, representing a retracement of approximately 68% of the initial rally. This retracement provided a buying opportunity for many traders who anticipated a continuation of the long-term bullish trend in gold.
**Crude Oil (2022):** After soaring to multi-year highs in June 2022, fuelled by geopolitical tensions, crude oil prices began to decline. The price retraced approximately 70% of the gains made earlier in the year, finding support around $76 per barrel. This retracement aligned closely with Schiff’s Law, offering potential entry points for traders expecting a rebound in oil prices.
**Natural Gas (2022-2023):** Natural gas experienced a dramatic price increase in 2022, reaching levels not seen in years. Subsequently, prices corrected sharply, retracing over 75% of the prior gains. This substantial retracement highlighted the volatility of the natural gas market and the applicability of Schiff’s Law in identifying potential reversal points.

These examples demonstrate that while Schiff’s Law isn’t foolproof, it frequently provides a reasonable approximation of price behavior following significant market movements. Analyzing price charts using tools like TradingView allows traders to visually confirm these patterns.

Limitations and Criticisms

Despite its usefulness, Schiff’s Law is not without its limitations:

**Market Specificity:** The law’s effectiveness can vary depending on the specific commodity and market conditions. Some commodities may exhibit more consistent retracement patterns than others. Market Breadth and overall economic conditions play a role.
**External Factors:** Unexpected economic events, geopolitical shocks, or changes in supply and demand can disrupt the expected retracement pattern. For example, a sudden supply disruption could prevent a commodity from retracing as deeply as predicted.
**Subjectivity:** Identifying the "significant move" that triggers the retracement can be subjective. Different traders might interpret price charts differently, leading to varying conclusions.
**Not a Guarantee:** Schiff's Law is a probabilistic observation, not a deterministic rule. There's no guarantee that a commodity will always retrace within the 66%-75% range. Prices can sometimes overshoot or undershoot the expected levels.
**False Signals:** Retracements can sometimes be false signals, leading to premature entry points. It’s crucial to confirm the retracement with other technical indicators and fundamental analysis. Using Elliot Wave Theory can help identify the structure of the retracement.
**Timeframe Dependency**: The law's effectiveness can vary depending on the timeframe being analyzed (e.g., daily, weekly, monthly charts). A retracement observed on a daily chart might differ from one observed on a weekly chart.

Therefore, relying solely on Schiff’s Law for trading decisions is risky. It’s best used as part of a broader trading strategy that incorporates other technical and fundamental analysis techniques. Consider employing Risk Management techniques, such as position sizing and diversification, to mitigate potential losses.

Schiff's Law and Related Concepts

Schiff’s Law shares similarities with several other concepts in technical analysis:

**Fibonacci Retracements:** As mentioned earlier, Fibonacci retracement levels often align closely with the 66%-75% range suggested by Schiff’s Law. Traders frequently use both tools in conjunction to identify potential support and resistance levels.
**Support and Resistance:** The retracement levels identified by Schiff’s Law often coincide with established support and resistance levels. These levels represent price points where buying or selling pressure is expected to be strong.
**Mean Reversion:** Schiff’s Law is based on the principle of mean reversion – the idea that prices tend to revert to their average value over time. Bollinger Bands are an indicator used to identify potential mean reversion opportunities.
**Correction Phases:** The retracement phase described by Schiff’s Law is essentially a correction phase in the overall trend. Understanding the characteristics of correction phases is crucial for successful trading.
**Wave Analysis:** Concepts from Elliott Wave Theory can complement Schiff’s Law, helping traders identify the structure of the retracement within a larger wave pattern.
**Candlestick Patterns**: Recognizing reversal candlestick patterns during the retracement phase can provide additional confirmation signals. Patterns like Doji, Hammer, and Engulfing patterns can indicate potential support or resistance.
**Volume Analysis**: Observing volume during the retracement can provide insights into the strength of the correction. High volume during a retracement might suggest a more significant reversal.
**Chart Patterns**: Identifying classic chart patterns like Head and Shoulders or Double Bottoms during the retracement can provide further confirmation of potential trend reversals.
**Trend Lines**: Drawing trend lines can help visualize the retracement and identify potential support or resistance levels.
**Japanese Candlesticks**: Analyzing Japanese candlestick formations during the retracement phase can reveal clues about market sentiment and potential reversals.
**Ichimoku Cloud**: The Ichimoku Cloud indicator can provide a comprehensive view of support and resistance levels, complementing Schiff’s Law.
**Parabolic SAR**: The Parabolic SAR indicator can identify potential trend reversals during the retracement phase.
**Stochastic Oscillator**: The Stochastic Oscillator can help identify overbought or oversold conditions during the retracement.
**Williams %R**: Williams %R is another oscillator that can be used to identify overbought or oversold conditions.
**Donchian Channels**: Donchian Channels can help identify breakouts and trend reversals during the retracement.
**Keltner Channels**: Keltner Channels can provide insights into market volatility and potential retracement levels.
**VWAP (Volume Weighted Average Price)**: VWAP can act as a dynamic support and resistance level during the retracement.
**Pivot Points**: Pivot points can help identify potential support and resistance levels during the retracement.
**Harmonic Patterns**: Harmonic patterns like the Gartley pattern can identify specific retracement levels and potential reversal zones.
**Intermarket Analysis**: Analyzing the relationship between different markets can provide insights into the overall economic environment and potential retracement patterns.
**Sentiment Analysis**: Gauging market sentiment can help assess the likelihood of a retracement.
**Order Flow Analysis**: Analyzing order flow data can provide insights into the buying and selling pressure during the retracement.
**Point and Figure Charting**: Using Point and Figure charting can help visualize price patterns and identify potential retracement levels.
**Renko Charting**: Renko charts can filter out noise and highlight significant price movements, making it easier to identify retracement patterns.

Conclusion

Schiff’s Law offers a valuable perspective on price behavior in commodity markets. While not a foolproof predictor, the principle of a 66%-75% retracement provides a useful framework for identifying potential entry points, setting profit targets, and managing risk. By combining Schiff’s Law with other technical indicators and fundamental analysis, traders can enhance their decision-making process and improve their chances of success. Remember that continuous learning and adaptation are crucial in the dynamic world of trading.

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