The Golden Ratio: Fibonacci retracements explained.

By Michael Wuetherick, P.Eng.  User Group Leader:  Red Deer Alberta August 11, 2015

Enhance your results by adding some gold…meaning add the GOLDEN ratio and Fibonacci retracements to your analysis!

The mysteries of the natural world have fascinated humans throughout history, science and innovation constantly strives to find the logical explanation of every phenomenon in the natural universe.   Just like the physical world, the stock markets appear random and unpredictable and seemingly impossible for investors to understand.  What do the size of galaxies, shells, tree rings, number of petals in a flower, the shape of the pyramids….and yes the stock market have in common?  Simple, the Golden Ratio!!

Each of these natural systems share natural geometric phenomenon described by Leonard Pisano Bogolla, an Italian mathematician knows as “Fibonacci” who first published his theory in his book Liber Abaca published in 1202.  The Fibonacci (“Fib”) sequence is 0, 1, 1, 2, 3, 5, 8, 13, 21, 54…etc.  The series starts with 0 and 1, and is derived by adding together the sum of the previous two numbers in the series increasing to infinity.

The Golden Ratio is calculated by dividing a number from the Fib series by the previous number, this number approaches 1.618 as the Fib number increases and is called the Golden Ratio!  The inverse of the golden ratio is 0.618, which is also equal to the ratio of any Fib number divided by the next highest number.  The key Fibonacci ratios are 23.6%, 38.2%, 61.8%, and the Golden ratio they share in common…1.618.

How can we use Fibonacci retracements to improve our technical analysis?

By now you no doubt are asking, what does this have to do with trading stocks?   Often the broad markets, and many liquid stocks will tend to pause and occasionally reverse at 23.6%, 38.2%, 61.8% and 100% of recent trading ranges.

Fibonacci retracements are one of the most powerful LEADING technical indicators of future market action.  For example, this chart is for the SPY ETF which tracks the S&P 500 broad market index.  To draw the retracement, start at the most recent significant low (Feb. 2, 2105) and end with the most recent high recorded on May 20^th, 2015.

Why did I select this range?  Well the VectorVest guidance turned decidedly negative around May 20^th with both a Primary Wave down and DEW down signal coming on May 23^rd along with guidance for prudent investors to move to the sidelines.  By combining the market guidance, and Fibonacci retracements I was able to forecast where to look for support/resistance levels going forward.

Here is the same Fibonacci chart, only updated to August 11^th, 2015.  Note the 5 key trend reversals that occurred at on very close to the Fibonacci retracements drawn weeks early….how cool is that!!

By combining the Fibonacci retracements and the appearance of strong reversal pattern candlesticks, you can increase the probability of playing the rally.  Let’s analyze how to do this with five examples from above.

1. June 9^th – Doji candlestick with the tail trading to a low of 207.69, essentially spot on with the 38.2% Fibonacci retracement suggesting likely low point support. Buy the SPY on June 10^th open at 209.37 and ride the short 2-3 day rally up!
2. June 15^th – SPY gapped down at the open and hit a low of 207.79, again right at the 38.2% retracement level before rebounding to close at 209.10 indicating a bullish “window open” bullish candlestick. Buy the SPY near the close on June 15^th or at the open on June 16^th and ride the 4 day rally up!
3. July 7^th – after a lengthy 10 day decline with high volatility, the SPY gaps up but immediately reverses on negative news out of Greece reversing the bullish open. The SPY aggressively sells off but starts to reverse of the low of 204.1, essentially spot on with the 61.8% Fibonacci retracement of 203.94. Are you starting to be a believer yet?!? SPY rebounds and closes near it the high for the day of 207.5 rallying 1.7% from the low of the day.
4. July 28^th – the market gaps up completing a morning star bullish reversal pattern formed from the previous two days price pattern. The star portion of the pattern on July 27^th reached a high of 207.55, just below the 38.2% Fibonacci retracement of 207.69. The set-up was there to by the SPY if the market opened above 207.69, which it did the next day and continued to rally for the next 4-5 days.
5. August 11^th – following a huge market day fueled by potential delays in US Fed rate hikes, the market completely reverses all of the gains after China announces its deflating their currency. The market gaps down and trades aggressively down with the SPY hitting a low of 207.76…you guessed it right at the 38.2% Fibonacci replacement level! While not a strong rebound

Since the onset of quantitative easing, investors have benefitted from the relative “ease” of following trends and relying on more commonly used technical indicators to help in managing positions.  However with the sideways, and often highly volatile markets we have been in for all of 2015 these methods don’t work as well.  Fibonacci retracements are an excellent tool for analyzing price action over any time period (i.e. minutes, days, week, months). Knowing where these points are can hopefully avoid irrational emotional decisions, or worse listening to the business media personalities!

Try to avoid putting your stop losses just above Fibonacci levels as you increase the probability of the market tripping your stop and them immediately heading back up.  Has anyone ever experienced that!?!  Alternatively, set your stops just below key retracement levels as if the market blows through a retracement it has a much higher chance of falling to the next level.  Don’t abandon your preferred stop technique, but when you get the alert to sell take a quick look to see what Fibonacci has to say before pulling the trigger!

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Michael Wuetherick, P.Eng. Red Deer User Group Leader, VectorVest Canada August 11, 2015