 Apr07

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Many years ago an Italian gentleman named Leonardo Fibonacci discovered ratios that exist throughout all of nature. These ratios are used to describe the proportions found in atoms as well as patterns found among stars and planets. These proportions help keep balance in the natural world and it also appears that stock markets exhibit a similar proportion.

One example of this ratio is found in bees. If you know the number of female and male bees in a hive, you can divide the number of females by the number of males and find the number will be 1.618. Another example that is easier to measure is the human body. First, measure the distance from the shoulder to the fingertip. Next, measure the length from the elbow to the fingertip. Divide the larger number by the smaller number and you will get a number close to 1.618. This quotient is referred to many times as the golden mean, the golden ratio or the divine proportion. Most everything contains measurable properties that will conform to this ratio. Even financial markets follow this same pattern.

In the world of stock analyzing, the golden ratio is normally expressed in three different percentages – 61.8%, 50% and 38.2%. When applying the Fibonacci ratios to stock trading, there are four main methods: fans, arcs, retracements and time zones.

Fibonacci Ratios in Stock Trading Methods

1. Fans – The fans, like the name suggests, are made from diagonal lines. The high price and the low price is first determined and then a vertical line is placed through the point furthest to the right. This line is divided to show 61.8%, 50% and 38.2%. From the point furthest to the left, three lines are drawn to the new percentage markers.

2. Arcs – Once again, the high price and the low price are identified. From the desired point, lines resembling mathematical compass curves are drawn to represent 61.8%, 50% and 38.2% distance from the point. These lines represent the resistance and support area as well as the range.

3. Retracements – Horizontal lines are used to show the points of resistance or support. After identifying the high and low prices on the chart, five lines are marked. The first line will be at 100% or the high point. The second line appears at 61.8%. The third line appears at 50%. The fourth line appears at 38.2%. The fifth and final line will be at 0% which is also the low point. Whenever a noticeable price fluctuation occurs, the new support and resistance areas will be within these lines.

4. Time Zones – This method is different from the previous ones due to the use of vertical lines drawn in series. The chart is divided into segments and the vertical lines are placed according to the Fibonacci sequence. The lines represent the expected area for price fluctuations.

History has a way of repeating itself, which is the foundation of stock analysis. The Fibonacci ratio and its application to stock markets is a wonderful tool in identifying the support and resistance for stock prices.