Jim Woods

What the Bleep is a Fibonacci?

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The investing game is chock-full of esoteric lingo and obscure mathematical and technical analysis models. All too often, the unfamiliar terminology and the complexity of the models leave the neophyte investor perplexed.

I recently received an e-mail from an OptionsZone reader that exemplifies just this state of confusion surrounding one frequently mentioned technical analysis tool.

The reader asked the blunt question: "What the bleep is a Fibonacci?"

To answer this question properly, we have to go all the way back to 13th-century Italy. It was then that a brilliant mathematician named Leonardo Pisano, who was nicknamed "Fibonacci," identified a sequence of numbers that possessed an unusual relationship.

Here is the famous Fibonacci number sequence: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. The relationship between these seemingly unrelated numbers is that each term in the sequence is simply the sum of the two preceding terms. This relationship persists into mathematical infinity.

The unusual characteristic of this numerical sequence is that each number is approximately 1.618 times greater than the preceding number.

So much for the "what" of the Fibonacci, now we need to know how this sequence of numbers and the relationship between them is applied to an analysis of the financial markets.

Fibonacci Trading

Technical analysts use the relationship between every number in the Fibonacci series as the basis for identifying the common ratios used in price retracement studies.

When technical analysts look at price action through the Fibonacci prism, they identify two extreme points (usually a major peak and trough) on a stock chart, and then divide the vertical distance by the key Fibonacci ratios.

And what are those key ratios? They are 23.6%, 38.2%, 50%, 61.8% and 100%. Once these rations are identified, they signify potential areas of support and resistance. The question now is why did the aforementioned ratios become the key ratios?

Well, here is where the Fibonacci ratios become really esoteric. The theory here is that in nature, and in the financial markets, systems will tend to display numerical characteristics that resemble key Fibonacci patterns. Beehives, spiral galaxies, the human anatomy and, yes, the patterns in the equity markets, all display profound and unequivocally non-coincidental Fibonacci patterns.