An Introduction to Fibonacci Numbers

April 7, 2012 Succesful Investing Skills No Comments

Before we get into Fibonacci numbers and how they are useful in determining the moves of stocks, I want to comment briefly on the Fed’s latest statement on the possibility of QE3 (Quantitative Easing). This week, they stated that the QE spigot has been turned off and not likely to open up in the future. The Fed is trying to squeeze 8 pounds into a 5 pound sack. On the one hand they need to keep interest rates low for “an extended period of time” in order to jump start the housing market and the economy in general, and on the other hand, they have to appear to be fighting the inflation monster that they created with their incessant introduction of liquidity into the system by creating money to throw at banks and the stock market.

They can’t do both, so they continue to throw money at the European banks, while telling the markets that there will be no QE3. On Tuesday and Wednesday, the Fed’s willing accomplices at the gold banks entered the COMEX and offered more gold for sale than the miners have produced in recent years. The markets reacted and the price of gold was driven down. This is a temporary fix that will not work for long, because gold will react and seek its natural level in relation to the amount of dollars that are being produced and floating around the globe.

Don’t let this manipulation of the gold market panic you out of your positions. Remember that this is an election year and the Fed will do anything it can to prop up the myth of the U.S. recovery in order to keep the game going!

Having cleared that up, let’s take a look at Fibonacci numbers and see how they work in a free market that is not being manipulated by the government.

Leonardo da Pisa

Fibonacci numbers are often touted when chartists are looking for support and resistance points. So, it is only natural to ask, who was Fibonacci and what are “his ” numbers all about? Fibonacci was born in 1175 AD and died in 1250 AD. If one thing can be said to be true, he changed forever how the Latin speaking world viewed numbers.

Fibonacci, his real name was Leonardo da Pisa, was born in Pisa in 1175 AD. He was born the son of a merchant, who also served as a customs officer in North Africa. Fibonacci traveled all over Algeria, which at that time was called Barbary, and while working, he did business in Egypt, Syria, Greece, Sicily and Provence.

In the year 1200 AD he returned to Pisa and wrote Liber abaci, which introduced the Latin-speaking world to the decimal number system. Before his work, the Latin speaking world wrote all of their numbers with letters. The decimal system that he wrote about used nine figures, 1, 2, 3, 4, 5, 6, 7, 8, 9 and the 0, which in Arabic is called “zephirum”. Fibonacci showed how with those ten numbers, any number of any size could could be written.

In Liber Abaci, Fibonacci introduced a simple series of numbers, that were later named Fibonacci numbers in his honor. The rule was incredibly simple and worked every time. The sequence begins with 0 and 1 and after that you follow the simple rule of adding the two previous numbers to get the next, as in 1, 2, 3, 5, 8, 13, 34, 55, 89, 144 and on and on.

The Fibonacci Summation Series

The Fibonacci Summation Series simply adds the proceeding two numbers in a series to produce the next number. The progression proceeds from 0, 1, followed by 1 and 1 which produces 2 and then 2 and 1 which produces 3 and then it continues to 5, 8, 13, 21, 34, 55, 89 and on to infinity. When the eighth series is reached, 55 is divided by by 89, which produces the golden mean number .618 and when you reverse it and divide 89 by 55 you you get 1.618. At this point, I will leave it to the mathematicians to explain the relevance of the mean number.

These ratios appear all over nature and can been seen in flower petals and sea shell spirals as well as in art, math, music and architecture. In the financial markets they will often predict where strong support or resistance will occur.

I don’t pretend to know why financial markets react the way they do when they hit Fibonacci numbers, but they do tend to reverse their movements or “bounce off” levels that coincide with the Fibonacci ratios. The bottom line is that individual stocks and markets in general, tend to reverse directions when they approach the Fibonacci number of 61.8%.

Because it happens so frequently, there are many traders that watch these numbers and their selling or buying amplifies the power of the ratios. On the occasions when the 61.8% fails to alter the direction of the price action, there are additional Fibonacci numbers that can come into play which include 78.6%, 127.2%, 161.8%.

This is not hard science, but the probabilities are enhanced by the use of Fibonacci numbers and they can and should be a tool that investors should take advantage of. Fibonacci numbers can give a trader a clue as to what the probabilities point to for a change in trading action by pointing out the likely areas for a reversal of the trend.

This is just one more tool that should be used when you are looking to gain an advantage when looking for a point to buy into an undervalued stock, or when you are looking for a point to take profits on the way up.

Simple, But Hopefully Helpful!

Keep in mind that my intent here was to give you a general idea on what Fibonacci numbers are and how they can be helpful in your day to day trading. There are many sites available on the internet that can give you more in depth information on how Fibonacci numbers work and what the mathematical principles are behind the numbers, but that is for those who are interested in really delving into the subject.

Just knowing what the Fibonacci retracement numbers are is all you really need to know to use them in your trading because they can help to point out where you might see a reversal of the trend.

Till next time, good luck and good trading!