Fibonacci and the Golden Ratio

There is a unique ratio that can be used to describe the proportions of everything from nature's smallest building blocks, such as atoms, to the most advanced patterns in the universe, like the unimaginably large celestial bodies. Nature relies on this innate proportion to maintain balance, but the financial markets also seem to conform to this "golden ratio." 

The golden ratio is derived from the Fibonacci numbers, a series of numbers where each entry is the sum of the two preceding entries. Although this sequence is associated with Leonardo of Pisa, the Fibonacci numbers were actually formulated for the first time by the Indian mathematician, Virahanka, 600 years prior to their introduction to the Western world.

Here, we take a look at some technical analysis tools that have been developed to take advantage of the pattern.

History of the Mathematics

Mathematicians, scientists, and naturalists have known about the golden ratio for centuries. It's derived from the Fibonacci sequence, named after the Pisan mathematician Leonardo Fibonacci, who lived from around 1175 A.D. until around 1250 A.D.

Although Fibonacci introduced these numbers to the Western world, they were actually discovered by Indian mathematicians hundreds of years earlier. The poet Pingala used them to count the syllables of Sanskrit poetry around 200 B.C., and the method for calculating them was formulated by the Indian mathematician Virahanka around 800 years later.

In this sequence, each number is simply the sum of the two preceding numbers (1, 1, 2, 3, 5, 8, 13, etc.).

But this sequence is not all that important. The essential part is that as the numbers get larger, the quotient between each successive pair of Fibonacci numbers approximates 1.618, or its inverse 0.618. This proportion is known by many names: the golden ratio, the golden mean, ϕ, and the divine proportion, among others.

So, why is this number so important? Well, many things in nature have dimensional properties that adhere to the ratio of 1.618, so it seems to have a fundamental function for the building blocks of nature.

Examples of the Golden Ratio

Don't believe it? Take honeybees, for example. If you divide the female bees by the male bees in any given hive, you will get a number around 1.618. Sunflowers, which have opposing spirals of seeds, have a 1.618 ratio between the diameters of each rotation. This same ratio can be seen in relationships between different components throughout nature.

The golden ratio also appears in the arts, because it is more aesthetically pleasing than other proportions. The Parthenon in Athens, the Great Pyramid in Giza, and Da Vinci's Mona Lisa all incorporate rectangles whose dimensions are based on the golden ratio. It seems to be unavoidable.

But does that mean it works in finance? Actually, financial markets have the very same mathematical base as these natural phenomena. Below we will examine some ways in which the golden ratio can be applied to finance, and we'll show some charts as proof.

Trading and Investing With the Golden Ratio

The golden ratio is frequently used by traders and technical analysts, who use it to forecast market-driven price movements. This is because the Fibonacci numbers and the golden ratio have a strong psychological importance in herd behavior. Traders are more likely to take profits or cover losses at certain price points, which happen to be marked by the golden ratio.

Curiously, the widespread use of the golden ratio in trading analysis forms something of a self-fulfilling prophecy: the more traders rely on Fibonacci-based trading strategies, the more effective those strategies will tend to be.

The Golden Ratio and Technical Analysis

When used in technical analysis, the golden ratio is typically translated into three percentages: 38.2%, 50%, and 61.8%. However, more multiples can be used when needed, such as 23.6%, 161.8%, 423%, and so on. Meanwhile, there are four ways that the Fibonacci sequence can be applied to charts: retracements, arcs, fans, and time zones. However, not all might be available, depending on the charting application being used.

1. Fibonacci Retracements

Fibonacci retracements use horizontal lines to indicate areas of support or resistance. Levels are calculated using the high and low points of the chart. Then five lines are drawn: the first at 100% (the high on the chart), the second at 61.8%, the third at 50%, the fourth at 38.2%, and the last one at 0% (the low on the chart). After a significant price movement up or down, the new support and resistance levels are often at or near these lines.

2. Fibonacci Arcs

Finding the high and low of a chart is the first step to composing Fibonacci arcs. Then, with a compass-like movement, three curved lines are drawn at 38.2%, 50%, and 61.8% from the desired point. These lines anticipate the support and resistance levels, as well as trading ranges.

3. Fibonacci Fans

Fibonacci fans are composed of diagonal lines. After the high and low of the chart is located, an invisible horizontal line is drawn through the rightmost point. This invisible line is then divided into 38.2%, 50%, and 61.8%, and lines are drawn from the leftmost point through each of these points. These lines indicate areas of support and resistance.

4. Fibonacci Time Zones

Unlike the other Fibonacci methods, time zones are a series of vertical lines. They are composed by dividing a chart into segments with vertical lines spaced apart in increments that conform to the Fibonacci sequence (1, 1, 2, 3, 5, 8, 13, etc.). Each line indicates a time in which major price movement can be expected.

The Bottom Line

Fibonacci studies are not intended to provide the primary indications for timing the entry and exit of a position; however, the numbers are useful for estimating areas of support and resistance. Many people use combinations of Fibonacci studies to obtain a more accurate forecast. For example, a trader may observe the intersecting points in a combination of the Fibonacci arcs and resistances.

Fibonacci studies are often used in conjunction with other forms of technical analysis. For example, Fibonacci studies, in combination with Elliott Waves, can be used to forecast the extent of the retracements after different waves. Hopefully, you can find your own niche use for the Fibonacci studies and add it to your set of investment tools.