Some investors believe that certain ratios are attractive to the human mind. Because of this, humans are likely to act in a manner that reflects these ratios. Investors have turned the observation of this phenomenon into a method for making money in the stock market. One set of ratios that investors use is derived from the Fibonacci sequence.
Learn the basics of the Fibonacci sequence, which starts with 1. Each successive number in the sequence is the sum of the previous two. Thus, the second number in the sequence is also 1 (1+0), The third number is 2, the fourth is 3, and the fifth is 5. The first 12 numbers in the sequence are 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144.
Note the significant ratios. Once you get beyond the first few numbers, the ratio of the larger to the smaller number in any pair of consecutive numbers in the sequence is around 1.618, the so-called golden ratio of mathematics, anatomy, woodworking and other disciplines. In stock market analysis, the percentages derived from the Fibonacci sequence are 61.8%, 38.2% (100%-61.8%) and 50%.
Create charts of a stock or index that you want to analyze using Fibonacci numbers. Look at one particular trend in the chart. For example, if a stock that is trading at $116 per share has been going up consistently since it stood at $100 per share, limit the chart to the period when the stock started moving toward $116.
Apply the ratios to evaluate a downturn. Check if the stock is going down more or if it is going back up. If the stock falls to $111 in one day (a 31.25% loss of the $16 upward trend), watch for it to hold above $109.89, which is 38.2% loss. If the stock stabilizes around that number, which is considered a support, it probably will go up. However, if it falls below that point, it is likely to fall all the way to the next support level, which is 50% or $108.
You can round off the ratios as 68% and 32%.
Fibonacci ratios closely approximate those of compound interest. Some people look at "the fibs" as a complicated way for explaining this phenomenon.
- Fibonacci ratios closely approximate those of compound interest. Some people look at "the fibs" as a complicated way for explaining this phenomenon.