Don’t discount Fibonacci numbers

The use of Fibonacci numbers in technical analysis is something of a Marmite issue. The idea that stock markets encounter resistance at ratios based on some magic numbers is a load of nonsense to some. But many use Fibonacci numbers, and the retracement levels of support and resistance they determine, as the bedrock of their technical trading strategies.

Fibonacci numbers were developed by Leonardo Fibonacci when he examined how fast rabbits could breed in optimal circumstances – producing a series of numbers based on adding the two previous numbers together to get the next (1, 1, 2, 3, 5, 8, 13, 21).

They occur in nature – in the number of petals on a flower, the number of seeds in a pod and in the hierarchy of a beehive. But, in one way or another, they also occur in the price action of financial instruments.

That markets follow patterns that fit with Fibonacci numbers is difficult to refute. But why they do so is up for debate. It could simply be that there is a critical mass of traders on desks around the world, all trading on Fibonacci levels – making the theory a self-fulfilling prophesy. Though some may see the fundamentals as dubious, Fibonacci levels are a mainstream technical indicator, used on the desks of big banks and with the power to move markets. After all, markets encounter resistance at certain numbers all the time, with no basis in any fundamentals. There is no reason why the market should react any differently to a 13,000 Dow over a 12,999 Dow, or Facebook dropping below $20 a share rather than to $20.01 a share. But it does.

A Fibonacci retracement is the potential retracement of a stock’s original move in price. This is plotted with horizontal lines to mark areas of resistance at Fibonacci levels. These horizontal lines are calculated by taking the trend-line between two extreme points and dividing the vertical difference between the two by the Fibonacci ratios of 23.6 per cent, 38.2 per cent, 50 per cent, 61.8 per cent and 100 per cent. For an example of this, look at Friday’s price action on the FTSE. Based on the July range of 5718.60 to 5478.00, a 50 to 61.8 retracement zone was formed at 5598.30 to 5626.6, with the 61.8 per cent resistance level triggering the end of a counter-trend rally.

Fibonacci levels should not be used in isolation. To confirm the retracement, you should look for a candlestick to form. If there is no reversal at the 38.2 level, you should look for a retracement to the 50 per cent level. But, by keeping an eye on this controversial indicator, you can help to glean advance warning that the market is about to change direction.