There is an observable pattern to the way the natural world is formed, if you know how to look. It’s a visible pattern that emerges from the growth of every tree, flower, and plant. Surprisingly, this pattern also applies to how we conduct business, including in the stock market. The pattern is called the Fibonacci sequence: a series of numbers that generates the next number by the sum of the previous two.
For example: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, etc.
As these numbers emerge in nature, so does the ratio of 1.618—referred to as the Golden Ratio. Almost everything in nature has properties of the Golden Ratio, and as many traders have discovered, the stock market follows this pattern, too.
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Fibonacci the Mathematician
In the 1200s, a young mathematician contemplated the following question:
“If a pair of rabbits is placed in an enclosed area how many rabbits will be born there if we assume that every month a pair of rabbits produces another pair, and that rabbits begin to bear young two months after their birth?”
The question seems odd, but the answer turned out to follow the Fibonacci sequence—a naturally occurring recursive doubling sequence that leads to exponential growth. This sequence can be seen all across nature; it’s the way limbs grow from tree trunks, how leaves grow on the stems of flowers, and how green onions grow their tops.
Fibonacci in the Stock Market
Fibonacci ratios, referred to as “retracement ratios,” are used in the stock market to identify potential price reversal levels. The ratios are derived from the distance between Fibonacci numbers. For example, three popular ratios are derived from the three Fibonacci numbers: 21, 34, 55.
(34-21)/34 is a ratio of 38.2%; (34-21)/55 is a ratio of 23.6%; and (34-21)/21 is a ratio of 61.8%
These ratios are applied to price charts to see where the retracements fall. Despite the complexity of the math, it’s not reserved for complex trades. For example, you can apply these ratios to price charts for any stock, including something as basic as wheat futures. In fact, it’s often beneficial to do so. Wheat is a popular futures contract, and for good reason.
RJO Futures says Chicago SRW wheat is “the most liquid wheat futures contract in the world, trading the equivalent of more than 15 million tons each day in 2013.” Applying the Fibonacci retracement ratios to a stock you’re already successfully trading can give you an even bigger advantage to calculate risk.
According to TradingMarkets.com, “Fibonacci analysis is a way to forecast levels of support and resistance and project price targets. It can be used to set stops as well as timing entries, however, the most valuable information is what it can tell us about risk.”
Putting Fibonacci into Action
To create the retracement chart, traders take two extreme points like a peak and a trough, and divide the vertical distance by three main Fibonacci ratios: 23.6%, 38.2%, and 61.8%. Horizontal lines are then created at each level to pinpoint potential levels of resistance and support.
Identifying these points can predict the potential points at which an asset’s price might reverse.
The Fibonacci ratios are just one indicator you can use as part of your trading strategy.
Where Did These Ratios Come From?
In the 1200s, a young man in his 20s named Leonardo Pisano Bigollo became captivated by mathematical ideas from India. Part of an important trading family, he traveled through the Middle East where he was exposed to these mathematical concepts. Returning to Pisa, Bigollo published the concepts in a book called Liber Abaci, which became a phenomenon across Europe and made him the most revered mathematician of his time.
Bigollo, lovingly referred to as Fibonacci, didn’t just outline mathematical concepts in his book. He wrote a discourse on how they applied to commerce.
At the time his book was published, Western civilization was still using Roman numerals, which made complex mathematics impossible. When Fibonacci came back from his travels, he brought with him the number system we use today called Arabic notation (originally from the Hindu system). Fibonacci detailed this number system in his book.
This new number system opened up new possibilities for the Western world that transformed mathematics, science, and commerce. To put it into perspective, imagine trying to solve complex algebraic equations using the Roman numeral system—it’s virtually impossible.
In this way, the Western world was limited by its number system without knowing it, and what Fibonacci brought back expanded our understanding and our ability to expand our worldview.
How have you seen the Fibonacci sequence at work?