Leonardo Fibonacci

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Leonardo Fibonacci: Predicting The Stock Market’s Next Move With The Fibonacci Sequence

By D. R. Barton, Jr., Contributing Editor
Wednesday, March 7, 2007: Issue #401

There’s nothing like a one-day, 400-point freefall for the Dow Industrials to shake up the faithful among the perma-bulls. But to be fair, those on the bearish side don’t have a whole lot to cheer about just yet, either.

So in the bull vs. bear battle, which side has it right? Is this just a little hiccup amid the third-longest bull run in market history? Or is all the bullish work of the past few months about to be unwound in a sustained move down?

Well, it’s said that a picture is worth a thousand words. So let’s look at a revealing chart that should shine some light on the current situation and give us a better idea of where to position ourselves going forward with the help of Leonardo Fibonacci.

Fire Up The Fibonacci Numbers

While a 13th century Italian mathematician named Leonardo of Pisa might not mean much to you, he’s more widely known as Leonardo Fibonacci. His work had been a mystery to the general public until it was popularized in the controversial book “The Da Vinci Code,” where his Fibonacci sequence was used in the clues of the book.

But long before the book (and subsequent hit movie) came out, many traders and investors were already familiar with Fibonacci’s work, as it offers key clues as to where indexes and stocks might be headed.

Interestingly, Leonardo Fibonacci did not actually invent the number sequence, but he is credited with popularizing it.

The sequence starts with 0 and 1, with the current number simply being the sum of the previous two numbers in the sequence. Thus, the sequence goes:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987, etc.

There are many trading applications of this number sequence, but the most used is the concept of the “golden ratio.”

A quick check of the numbers in the sequence will show that dividing any smaller number in the sequence by the next larger number yields the ratio of 0.618 and that dividing the larger by the next smaller number gives 1.618 (the smallest few numbers in the sequence only approximate this ratio).

Leonardo Fibonacci Cracks The Market Code

Traders use Fibonacci ratios to project potential retracements of market moves to find logical turnaround points. And the key retracement levels that many traders look at are 0.382 (38.2%), 0.50 (50%) and 0.618 (61.8%).

The question is… what does the Fibonacci sequence reveal about the current market pullback, and how far will the market decline before it resumes its upward movement? Let’s turn to the chart…

3 Numbers That Will Determine The Strength Of This Market Correction

Take a look at the S&P 500 chart below, which shows the index’s impressive upward run from the July 2006 lows to the February 2007 highs.

SnP 500 upwards run from July '06 - Feb '07 As you can see, by using Leonardo Fibonacci’s ratios, there are basically three major Fibonacci retracement points on the chart. Here’s what they reveal:

If The Pullback Is Weak: You’ll see the S&P edge down to the 38.2% retracement level at 1,371.18

If The Pullback Is Normal: In this case, you’d see the index retrace to the 50% level at 1,343.26

If The Pullback Is Strong: If we’re set for a more severe correction, then the index will slide back to the 0.618 retracement point (61.8% of the price move being measured) at 1,315.34. This would be the last area of support before the trend would be considered broken.

Decision Time For The Market

If this pullback is only a mild one, then the area around the 0.382 retracement line on the chart should hold and prices on the S&P 500 cash index shouldn’t close below the 1,370 area.

But a close below that area would mean that a move down to 50% retracement level at 1,343 is expected. And if you look at Monday’s closing price, as well as today’s opening price, you’ll see that the market was a mere three points from testing the 0.382 retracement level.

Bottom line: If that level isn’t pierced, it’s good news for the bulls. If it breaches that point, and closes below it, then more downside is probable.

While no analysis can be correct every time, learning from Leonardo Fibonacci and watching retracement levels can give you a key edge in your investing strategy.

Great trading,

D. R. Barton, Jr.