If you think Fibonacci was just a crazy Italian mathematician, consider this: The May 2 high at 1,370 and the June 16 low at 1,258 occurred right against Fibonacci resistance/support.
What exactly is Fibonacci? How do you calculate Fibonacci levels? Why do Fibonacci levels work? What’s the evidence? How do you trade with Fibonacci?
This article is going to be a bit longer than my normal articles, but hang in there; it will be well worth your time. The answer to the questions above might be the single most important investment secret you’ve ever read.
What exactly is Fibonacci?
Fibonacci, a 12th century Italian mathematician, was the first to mathematically express an aesthetical proportion that has fascinated and influenced mankind for thousands of years.
This proportion is known as Phi or the Golden Mean and is derived from the Fibonacci sequence. The Fibonacci sequence starts out like this:
0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.
Each number of the sequence is the sum of the two preceding numbers. The ratio of each successive pair of numbers in the series approximates Phi. The ratios of successive numbers in the series quickly converge on Phi. After the 40th number in the series, the ratio is accurate to 15 decimal places. Fibonacci numbers have certain defining properties:
Division of the preceding number by the subsequent numbers tends to 0.618. Division of the subsequent number by the preceding number tends to 1.618. Division of a number by the second preceding number tends to 2.618.
Division of a number by the second subsequent number tends to 0.382.
Fibonacci Everywhere
The Golden Mean is found in the universe, humans, animals, plants, DNA, music, the bible, ancient architecture, and biology. On your next leisurely stroll notice how many flowers are adorned with a Fibonacci number of petals.
Lilies have 3, buttercups 5, delphinium 8, Marigold 13 and sunflowers either 34, 55 or 89 depending on size. Sunflower seeds are arranged in a number of clockwise and anti-clockwise spirals containing 55 or 89 seeds.
The Golden Ratio is also found in architecture and can be seen in the Great Pyramids of Egypt, the Parthenon in Greece, Notre Dame in Paris, Taj Mahal in India, the CN Tower in Toronto, and the United Nations building in New York.
It could be said that the Golden Ratio is in our DNA - literally. The DNA molecule, the program for all life, is based on the Fibonacci sequence. It measures 34 angstroms long by 21 angstroms wide for each full cycle of its double helix spiral. 34 and 21 are numbers in the Fibonacci series and their ratio closely approximates Phi.
Why do Fibonacci Levels Work?
Perception is one of the most powerful forces on Wall Street. Perception is created by the collective mind of investors and is ultimately reflected in the price of a stock or index.
To visually understand what a stock or index is and has been doing we’ve created charts. Who doesn’t look at and consult a chart before buying or selling a stock or ETF?
If humans are drawn to Fibonacci shapes, forms and ratios everywhere in their daily lives, would it be a stretch to conclude investors – albeit unconsciously – are drawn to Fibonacci formations when it comes to charts?
What’s The Evidence?
A picture says more than a thousand words. The chart below highlights four Fibonacci levels the ETF Profit Strategy Newsletter has highlighted repeatedly over the past year.
The yellow lines either represent Fibonacci retracement levels going back to the March 2009 bottom, or projection levels (also called extensions) going back to the 2002 bottom.
Fibonacci levels are not only accurate, they are also versatile. Shown above are Fib levels for the S&P (SNP: ^GSPC), but Fibonacci can also be applied to the Dow Jones (DJI: ^DJI), Nasdaq (Nasdaq: ^IXIC), small caps (NYSEArca: IJR), mid caps (NYSEArca: IJH), large caps (NYSEArca: IVV) as well as commodities (NYSEArca: GSG).
Sectors like financials (NYSEArca: XLF), consumer discretionary (NYSEArca: XLY), basic materials (NYSEArca: XLB) or technology (NYSEArca: XLK) are also not immune to the allure of Mr. Fibonacci. But my recommendation is to do just one index and to do it well. I tend to stick with the S&P.
How to Trade/Invest with Fibonacci Levels
A number of factors go into identifying high probability set ups. The general premise is to sell against resistance and buy against support.
This sounds simple but is easier said than done. The spike that sent the S&P by one point over the 1,369 Fibonacci resistance level was caused by news of Osama Bin Laden’s death. Who would want to short the market right as the nation’s biggest villain has been eliminated?
But Fibonacci tends to be more powerful than news, that’s why the ETF Profit Strategy Newsletter recommended on May 1 to short the S&P against 1,369 with a protective stop-loss above.
How about buying when everyone is selling? On June 16, the very day the S&P fell to its 1,258 low, the following headlines were featured on various credible websites:
“Is the Bull Market Over? A look at four different sentiment measures suggests that more pain may await investors.” – Barrons.com
“Greek default could trigger chain reaction” – AP
“Confidence is eroding among U.S. factories, consumers, economic data shows” – Bloomberg
The ETF Profit Strategy Newsletter trusted Fibonacci more than the media. The June 15 update stated: “While allowing for an intraday capitulation decline, unless we see a close below 1,249, the current range is seen to be between 1,250 and 1,300. Therefore, the up side potential is larger than the downside risk. A drop into the 1,259 – 1,245 range would prompt us to close out short positions and leg into long positions.”
The 1,250 – 1,300 trading range has remained intact ever since and the recommendation has been to sell 1,298 Fibonacci resistance and around 1,255 Fibonacci support.
Sooner or later the market will break out of this range (yes, even Fibonacci levels will be broken) and enter the next range. But as long as the market remains choppy it’s best to subdivide the market into incremental trading ranges (such as 1,369 – 1,298, 1,298 – 1,255, 1,255 – 1298) and don’t be shy about taking profits. This beats the buy-and-hold approach.
But even if you prefer to stick with buy-and-hold, you can use Fibonacci levels to lighten up on equities and rebalance or add equities. The principle – sell against resistance, buy against support – remains the same.
The ETF Profit Strategy Newsletter calculates important Fibonacci levels and enhances them with various aspects of technical analysis and sentiment readings. The result is succinct analysis with easy to follow recommendations.
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