THE use of Fibonacci numbers to predict stock market movements is not something on which there is a universal consensus. Some swear by them while some see them as a lot of nonsense. Whatever your view, it may be worth taking a look at this example of a system that can often track market reversals and retracements with some accuracy.
Fibonacci numbers were developed by Leonardo Fibonacci when looking at the question of how fast rabbits could breed in optimal circumstances (Barry White LP, a bottle of Blue Nun and a field full of dandelion leaves et cetera). Predictably, the resulting sequence is simply a series of numbers based upon adding the two previous numbers together to get the next (1, 1, 2, 3, 5, 8, 13, 21).
Fibonacci numbers occur in nature, in the number of petals on a flower, the number of seeds in a pod and the hierarchy of a beehive. They also exist in the world of financial markets and it is the relationship between these numbers that gives us the common Fibonacci retracements pattern in technical analysis.
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 the 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.
If you look at the chart on the top left, you can see that stocks often retrace a percentage of the previous move before reversing. Although 50 per cent is not a Fibonacci number, it is a useful point to mark on your chart as stocks often reverse after retracing half of their previous move.
Though assets may often follow this pattern, you shouldn’t simply buy as soon as you see signs of a reversal at a Fibonacci retracement level. At the 38.2 per cent level, you should look for a candlestick pattern to develop. If there are no signs of a reversal at this point then you should look for a possible retracement down to the 50 per cent mark and look for a retracement there. To confirm a breakout or a reversal, you need to make use of other technical indicators and candlestick formation to confirm it, though marking Fibonacci retracement levels on the graph will give you a useful alarm to let you know that something is going to happen at that level.