A Few Ways Fibonacci Can Be Helpful
A technician has many many tools. But what a lot of people fail to realize is that all of these are just a supplement to the most important thing we have, which is price. Over the past few months I've received a bunch of emails and comments questioning the significance of Fibonacci numbers and people asking me to explain how I use it as a tool.
So let's start with how the Fibonacci Sequence was first discovered. Liber Abacci, first published in the year 1202, was a book on arithmetic written by Leonardo of Pisa. We know him today as Leonardo Fibonacci. In the book, a problem is posed that first gave rise to this sequence of numbers: 1,1, 2,3,5,8,13,21,34,55,89,144, and so on to infinity. The problem was this:
How many pairs of rabbits placed in an enclosed area can be produced in a single year from one pair of rabbits if each pair gives birth to a new pair each month starting with the second month.
From Elliott Wave Principle:
"In arriving at the solution, we find that each pair, including the first pair, needs a month’s time to mature. But one in production, begets a new pair each month. The number of pairs is the same at the beginning of each of the first two months, so the sequence is 1, 1. This first pair finally doubles its number during the second month, so that there are two pairs at the beginning of the third month. Of these, the older pair begets a third pair the following month so that at the beginning of the fourth month, the sequence expands 1,1,2,3. Of these three, the two older pairs reproduce, but not the youngest pair, so the number of rabbit pairs expands to five. The next month, three pairs reproduce so the sequence expands to five. The next month, three pairs reproduce so the sequence expands to 1,1,2,3,5,8 and so forth."
So basically the sum of any two adjacent numbers in the sequence forms the next higher number in the sequence: 1 plus 1 equals 2, 1 plus 2 equals 3, 2 plus 3 equals 5, 3 plus 5 equals 8, and so on to infinity.
Why is this important? Well after the first several numbers in the sequence, the ratio of any number to the next one higher is approximately .618 to 1 and to the next lower number approximately 1.1618 to 1. The further along the sequence, the closer the ratio approaches 0.618 (or 61.8%). Between alternate numbers in the sequence, the ratio is approximately .382, whose inverse is 2.618.
How do we use these numbers to our advantage? Well, we find them all around us everyday in nature. From the sizes of our arms relative to our torso, to the construction of Hurricanes, to Rams horns and even in our DNA. The more you dig into it, the more amazing this phenomenon becomes. But regardless of all that, the market cares. So we care. Go back to the market lows after the crash of 1987 and see where the 2009 bottom was after correcting from the 2007 top. Amazing stuff.
When markets are trending and a correction comes, and I mean any market: stocks, bonds, commodities and currencies, they tend to stop at certain levels before resuming the underlying trend. These levels are 38.2% and 61.8% of the previous move higher (or lower in a downtrend). We see this time and time again. But we're not just buying because we're at a Fibonacci level, it's when these levels coincide with former support and resistance areas that it really becomes valuable. As I mentioned in paragraph 1, sentence 2 of this post, Fibonacci is just a supplement to price like everything else. If price says you have a good risk/reward AND you're at a key Fibonacci level, I pay more attention, and will probably put on bigger size. Throw in a momentum divergence and maybe some sentiment extremes and you could have a home run trade.
Here is a good example of the Nasdaq100 finding support in April near 38.2% of the rally that started in November, before resuming its uptrend:
Fibonacci also comes into play when we're at levels never seen before by a market. We've had this dilemma throughout the year as S&Ps were breaking out to all-time highs and we've had nothing to refer to in the past because we had never been up there. What I like to do then is take the most recent correction in the market, and once we breakout to new highs, figure out what the 1.618% and 2.618% extensions of that prior move would be to come up with an area of potential supply. You can use that level to take profits or even put on a short, if that's what you're into.
Here's a good example:
And these are the 2 biggest ways that I use Fibonacci. But that's just me personally. I also get asked a lot whether I prefer to use absolute highs and lows or closing prices. The answer is I use both. You can see in the example above that Regional Banks ($KRE) could barely hang on to the 161.8% level and was barely able to exceed it to run into the 2.618% extension of closing prices. I thought that cluster of extensions was interesting.
Time is a big factor as well. I know some smart guys that use the Fibonacci sequence in their cycle work and has helped them spot key turning points in the market. Like anything else in life, I can't use every tool and indicator that we have at our disposal. But feel free to dig deep and see how Fibonacci can help you. Everyone is different. But I thought I would share how it helps me.
Here's to our boy Leo Fibonacci, one of the great mathematicians in history.
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