Fibonacci numbers in mathematics are a sequence formed by adding the previous two numbers together to generate the next number. For example, the series starts off 1, 1, 2, 3, 5, 8, 13, etc. An interesting property is that the next number is approximately 1.618 times the previous number.
A 19th century trading guru named Gann made a big deal out of them, and traders and investors started believing that they can predict market movements.
In fact, many technical indicators were developed using these numbers, including:
1. Gann lines - these are angled lines that are plotted on charts. They use 1 and another Fibonacci number to advance the x and y axis on the chart. For example, the 1 x 1 Gann line is drawn at 45 degrees (each new point on the line is moved 1 box horizontally and 1 box vertically). There are also 1 x 2, 1 x 3, 1 x 5, 1 x 8, etc. Gann lines.
2. Retracements - If a Fibonacci number is divided by the next number in the sequence, you get 61.8%. If you divide a number by the number 2 places ahead, you get 38.2%. According to Fibonacci retracement, after a market makes a big move, it will retrace back 38.2%, 50%, and even 61.8%. These are supposed to be "mysterious turning points".
The truth about Fibonacci is that it is a combination of "gurus" selling books, selective examples, and self-fulfilling prophecy.
Fibonacci allows trading system vendors to design systems that seem to be mathematical and scientific, with a large degree of certainty. People trying to master trading buy these books and systems because they tend to be well educated professionals who want trading to be as neat and cut and dry as their professions.
Instead, Fibonacci promoters tend to cherry-pick example trades that show that it works. They don't include examples where the market fails to retrace, or else blows right through the number without turning.
Finally, at times when there are no strong fundamental news events to move prices, a market will turn at Fibonacci points because so many people use Fibonacci points. Long term, of course, markets move because of supply and demand.
Fibonacci numbers can't predict the market. At best, they help you manage your trade - to pinpoint entry and exit points (of course, there is nothing magical about using a Fibonacci number as a stop - it is as good as any number. The main thing is to be disciplined to stick to your plan).
Incidently, Fibonacci introduced this number sequence to the West (it was previously known to Eastern mathematicians) to describe the theoretical breeding patterns of rabbits - so it turns out to be a coincidence that I mentioned the Easter Bunny in the title!
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Praveen Puri has been a full-time trader, financial software developer, and a vice president at a major bank. He has appeared on MSNBC.com, NBC.com, The Wall Street Journal, FINS, and Wise Magazine.
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