Fun With Fibonacci

12th century monk Leonardo de Pisa, better known to his friends as Fibonacci, discovered a fascinating mathematics sequence that appears throughout nature. Beginning with a simple 1 + 1, the sum of the last two number sets that precede it creates another Fibonacci value:

1+1=2 1+2=3 2+3=5 3+5=8 5+8=13 8+13=21 13+21=34 21+34=55 etc, etc.

For reasons that remain unknown, major ratios drawn from these numbers describe a predictable interaction between trend and countertrend movement in markets. The most important ones to remember are 38%, 50% and 62%. Applying these percentages to trending price predicts the extent of retracement contrary to the underlying trend, as well as how far a new high or low will travel. For traders, these hidden points represent invisible support/resistance zones where prices will hesitate and/or reverse.

Fibonacci numbers closely relate to Elliott Wave theory. However, using them requires only a short primer in that arcane study. At the minimum, develop the basic understanding that primary trends travel in 5 waves (3 forward and 2 backward) while countertrends move in 3 waves (2 forward and 1 backward). That's all you need to easily manipulate Fibonacci price grids.

Grab some charts and a good charting program. All good technical analysis software has this Fibonacci function. For example, both SuperCharts and Real Tick allow custom entry of all major points. Lay Fib lines over the extremes of dynamic trends using the Fibonacci Grid. Or just take a calculator and measure swing action from intraday, daily or weekly quote listings.

Placed correctly, you'll notice that most markets swing off Fibonacci ratios as they move from support to resistance and back. Once you get the knack of it, you'll see that trends in all time frames have common elements and similar proportionality.

Trade decisions using Fibonacci retracement must include entry/exit analysis (risk:reward) with respect to key pivot points. Focus on getting into a market at major ratios while standing aside as price hovers between key zones. Most times, the smartest execution will be counter the most immediate short-term trend.

Hidden Support & Resistance

Fibonacci defines trend movement over broad time frames as well as very short ones. On this weekly chart of CPQ, note how the 38%, 50% and 62% retracement of the strong 1997 rally have defined the broad base under construction for almost two years.

Retracement science works in bear markets as well as bull markets. Major market plunges frequently recover 50% or 62% of the last selloff before continuing the decline.