If you’re beginning to dabble in the stock market, it won’t be long before you start hearing about Fibonacci trading, Fibonacci numbers, Fibonacci retracement, and so on. Every discipline has its own jargon, but this sounds like it’s something much more than merely a special name for something. A whole lot more, in fact, which appears to be rather complex. However, before you run screaming from the room, let’s have a look at what a Fibonacci sequence is. Sometimes when you break things down and look at them a bit at a time, they are a lot less frightening.
Named after the Italian mathematician who first set out the idea in the thirteenth century, the Fibonacci sequence starts with the numbers 0 and 1 as the first two numbers in a list. The next number, and each one that comes after, is the sum of the two numbers that came directly before it. So the next number in this sequence would be 1 (the sum of 0 and 1). The number after it would be 2 (the sum of 1 and 1), then 3 (2+1), 5 (3+2), and so on. So the beginning of the Fibonacci sequence would look like this: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, and on into infinity.
Creating a number sequence like that is interesting enough in itself, particularly for math geeks. But the numbers have other sorts of relationships to each other that make this sequence downright intriguing. Each number in the series is about 1.618 times larger than the number that came before it. And you get certain common ratios each time that you divide one number in the sequence by another one that stands in a particular relationship to it. In fact, there are three of these ratios that seem to be important in the stock market world.
The first ratio comes when you divide a number in the sequence by the number that comes directly after it. So if you divide 8 by 13, or 8/13, you get 0.6153. Divide 55 by 89, or 55/89, and it’s 0.6179. Rounding the results, it seems that doing this type of division tends to hover at a ratio of 61.8%. People who study the Fibonacci sequence call this the “golden ratio.”
For the second important ratio, a number is divided by the number that comes two places after it, instead of one. So for example, dividing 55 by 144, or 55/144, would give you a 38.2% ratio. And the third ratio is found by dividing a number by the number that comes three places after. So 8 divided by 34, or 8/34, gives you 0.2352, or when averaged with other similar divisions, a ratio of 23.6%.
You may wonder what any of this has to do with stock market trading. First of all, these ratios seem to play a role in how things happen in nature. For example, the number of petals on almost all flowers is a Fibonacci number. Many architects use the golden ratio in the design of their buildings. And for some reason, the Fibonacci numbers and their ratios also seem to play a role in how the stock market behaves.
If prices are trending in a certain way and there’s some sort of reversal, they usually retrace their steps backwards to a point somewhere between where they originally started, and the highest (or lowest) point they had reached before turning back. The point where they stop retracing, and head back upward (or downward), is usually at a place that can be identified with one of the ratios associated with the Fibonacci sequence. So if a price started at zero and had reached 100 before turning back, it would stop somewhere around 23.6, 38.2, or 61.8, and start upward again. There are a couple of other ratios that also have an effect for different reasons, but the Fibonacci ratios are very important.
No one is quite sure why this is the case, but this fact does seem to correspond with the fact that the Fibonacci numbers seem active in the world in general. These ratios may be why so many people consider the stock market almost an inevitable, nature-driven process in itself, and view it as having something almost like divine status. Whatever the reason for this interesting connection, it means that if you want to play the stock market in a serious way, you pretty much have no choice. You’re going to need to learn something about the Fibonacci numbers, and how they relate to trading.