Fibonacci Retracement

Brian Hicks

Updated November 12, 2009

It goes without saying that it is the uncertainty about our investments that makes them so confounding.

Like a great mystery, they lay out before us. . . fuzzier than most people are willing to admit.

In this case, unease is the rule rather than the exception — especially in today’s markets, which make about as much sense as David Blaine does when he levitates above the sidewalk.

Sure it looks amazing, but is it real? Our experience would tell us otherwise.

For investors with a penchant for technical analysis, that unease invariably ends with a trip into the past. For those who swear by it, the lines on those charts are much more than mere points on a graph.

Instead, they are windows into a world where the markets actually begin to make sense. 


You see, there really is something to be learned from the patterns that repeat themselves in the market. And while no two markets are exactly alike, the reality is markets tend to rhyme.

That, at its core, is what technical analysis is all about. For those who understand it, the markets are much more orderly.

And aside from the basics of using support and resistance to pick entry points, using Fibonacci numbers is one way traders can take the mystery out of the markets.

What Exactly are Fibonacci Numbers?

In many ways, Fibonacci numbers form the ultimate pattern, since they are found in things all around us — particularly in nature.

For instance, nearly every flower has a number of petals that is a Fibonacci number, while the construction of a pine cone is ruled by them. Even the dimensions of a strand of DNA are proportional to two consecutive Fibonacci numbers.

First recognized by Leonardo da Pisa, also called Fibonacci, these patterns are sequences of numbers that build upon themselves, beginning with the number 1. The sequence that follows is created by adding two consecutive numbers. . .

For instance, consider this sequence: 1, 2, 3, 5, 8, 13, 21, 34. . . and so on.

As you might have guessed, it’s not as random as it looks. A closer inspection reveals that every number in the string is actually the sum of the prior two.

What’s more, the ratio between two successive numbers is always the same: 1.618 — otherwise known as the golden ratio. Think of it as one of "nature’s laws." This ratio can be found nearly everywhere you look.

For some odd reason, this includes the stock market; traders agree that Fibonacci numbers can be used to determine the critical points that can cause an asset price to reverse.

This phenomenon is known as a Fibonacci retracement, and it often gives the traders who track these numbers an opportunity to re-enter the market on a pullback before the move resumes.

These retracements usually occur at the 23.6 %, 38.1%, 50%, 61.8%, and 78.6% levels, which are ratios related to the Fibonacci sequence. It is at those specific points where the share price of a stock can either meet resistance or find support.

Why that is. . . no one knows for sure. I suspect it is because everyone is working from the same playbook.

Regardless, I’ve come across these numbers so many times that they are hard to ignore. Bull market or bear market, Fibonacci numbers create price targets across multiple time frames.

How to Calculate Fibonacci Retracement Levels

To calculate these levels and plot them on a chart, you simply calculate the price distance between a major peak and a major trough. Needless to say, there have been plenty of those lately.

For instance, let’s take a look at the 12,012 point run-up in the Dow Jones Industrial Average from the October crash in 1987 until the peak of the bubble in 2007.

To figure out the corresponding Fibonacci levels, you would simply divide that amount by the ratio: (12,012 x .236 = 2834)

Finally, subtract that number from the swing point high: (14000 – 2834 = 11165) 

That will give you your Fibonacci level.

Doing so you could have established the following levels of support:

  •        A 23.6% retracement of 11,165 (the figure in our example)
  •        A 38.1% retracement of 9,411
  •        A 50% retracement of 7,994
  •        A 61.8% retracement of 6,576
  •        A 78.6% retracement of 4,558

Coincidently, if you look back at the DOW charts, you will see the first wave the downtrend bounced at roughly 11,100; the second wave of the down trend bounced at 7900; and the final wave of the downtrend bounced at exactly 6547.

The Road to Dow 11,000

That brings us neatly to today. As we mentioned earlier, Fibonacci numbers can also be used to plot targets in a bear market bounce.

In this case, we would measure the distance from the peak of 14000 in 2007 to the most recent trough of 6547.

Working from those figures would give us the following Fibonacci retracement levels on a chart of the DOW:



In turn, those figures would be our price targets marking what could be expected in a bear market rally off of the lows. So far, they have been pretty accurate.

That leaves 11,152 as the next upside target in the rally which would complete a 61.8% retracement of overall decline. Coincidently, that would bring us on a round trip back to September 2008 when the wheels basically came off the wagon. What’s more: that would also bring us roughly to the top of the downtrend line drawn from the peaks.

But let’s not get ahead of ourselves. . .

First, we have to see how the DOW handles the 50% level which was reached yesterday. That’s often a sign the market may need to pullback to work off overbought conditions in the short term. Even still, we would expect the move to be shallow since the underinvested in this climb have been quick to take advantage of lower prices.

For what its worth, that’s take a look at the crystal ball. That’s why we’re leaning bullish with our sights on Dow 11,000 at the moment.

After that, we suspect it’s a whole new ballgame.

And if math is not exactly your thing, there’s an app for that. Here’s a link that will calculate Fibonacci retracements for you. It tends to be more accurate than my pencil-and-paper method and it’s a bit easier.

Picking stocks in a market like this is whole lot tougher than one might think. That’s why selecting the proper entry points is always the key to making winning trades. In fact, using methods like this one, The Wealth Advisory team has identified a biotech stock that we think will make a 66% run to the upside by May 1st. To learn more about this opportunity, click here. 

Your bargain-hunting analyst,

steve sig

Steve Christ, Investment Director

The Wealth Advisory

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