From the March 01, 2012 issue of Futures Magazine • Subscribe!

Fibonacci: Trading the numbers game

Since the inception of the Internet bubble, retail interest in trading financial markets has gone up exponentially. Many traders are looking for that one method or indicator that at least will slant the odds in their favor on the road to consistency. Many believe that one method is the Fibonacci retracement.

The Fibonacci method is one tool in a group of methodologies (such as Elliott Wave and Gann) that seeks to tap into and exploit an underlying universal structure of all markets. Simply put, if this structure provides the apparatus within which markets move, then measuring it and the market’s place within it will give you an exceptional edge.

While Fibonacci is a good method for uncovering the market’s hidden order, and reliable in the right hands, it must be analyzed in the proper context. Traders also should maintain realistic expectations of what Fibonacci can, and cannot, do.

Numbers game

Fibonacci numbers are derived from the work of Leonardo de Pisa de Fibonacci, who was a 13th century mathematician. He popularized a series of numbers, later named after him, that increases by the sum of the preceding two numbers. It is, 1 (0+1), 2 (1+1), 3 (2+1), 5 (3+2), 8 (5+3) and so on until we get 21, 34, 55, 89, 144, 233, etc.

We know that markets don’t go straight up or down, making them difficult to predict. Our interest is in universal price movement, the understanding of which gives the trader a better chance to manage risk. But the Fibonacci series alone does not help manage risk in terms of price retracements. However, it does correspond to natural, universal price movement in terms of time.

According to Fibonacci methodology, a move from point A to point B in any time frame can retrace either 38.2%, 50%, 61.8% or 78.6%. Other important numbers also come into play here. Briefly, the golden spiral number of 0.618 squared is 0.3819 and the square root of 0.786 is 0.886. That’s why those numbers work as retracements. While 50, or one-half, does not have a tie to Fibonacci, W.D. Gann, another analyst who pioneered research in the order of the markets, popularized the hypothesis that a move will correct half of its progress before it rejoins its main trend.

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