You ever get the feeling while browsing around financial websites, or even reading the financial section of the newspapers, that you need a translator or specialized knowledge just to understand what the heck's going on?
Divergence, convergence, MACD, moving averages, resistance points, Fibonacci retracements, etc. Not quite Greek. But for some people it may as well be. So today we are launching our Investor's Dictionary.
We don't intend to cover the very basic stuff. We're not going to define a bond, a stock, a mutual fund, and other elementary things. For that I refer you to our Investor Education Net Links and to your About.com Guide to Investing for Beginners, Ken Little. What we plan to cover here are some of the more advanced topics, which aren't really all that complicated, but are more involved than the basics. And we plan to cover them in short succinct, easy to understand items.
Today we start our discussion with an interesting concept called Fibonacci Numbers.
First, let's explain that Fibonacci Numbers are a mathematical concept. It's a sequence of numbers in which each term is generated by the two previous terms and was discovered by Italian mathematician Leonardo Fibonacci in the Thirteenth Century. The first two terms are 0 and 1 and the Fibonacci sequence is as follows: 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, etc.. Each number except the first two is formed by adding the previous two in the sequence.
Why are these numbers significant? They have been found to be a common pattern in nature. For example, the number of petals on flowers are often a Fibonacci number. Lilies and iris have 3 petals, buttercups have 5 petals, some delphiniums have 8, corn marigolds have 13 petals, some asters have 21 and daisies can have 34, 55 or even 89 petals.
Fibonacci numbers also show up in the spirals in the seed heads of sunflowers, in the patterns of a pine cone, and in the spiral shape of some seashells.
How do they apply to investing? Well! Read on!
Some theorists have noticed Fibonacci numbers in the up and down price movements of stocks in the stock market. If you take any adjacent pair from the sequence of Fibonacci Numbers and divide each by their sum, an interesting pattern develops as shown in the table below.
| 1, 2 | 1/3 = 33.3% | 2/3 = 66.6% |
| 2, 3 | 2/5 = 40% | 3/5 = 60% |
| 3, 5 | 3/8 = 37.5% | 5/8 = 62.5% |
| 5, 8 | 5/13 = 38.5% | 8/13 = 61.5% |
| 8, 13 | 8/21 = 38.1% | 13/21 = 61.9% |
| 13, 21 | 13/34 = 38.2% | 21/34 = 61.8% |
Each pair adds up to 100% and as the numbers get larger, the two pairs settle around 38.2% and 61.8%. Furthermore, each number in the sequence is approximately 1.618 times the previous number and .618 times the following number.
Some analysts noticed that a stock's price movements often followed a Fibonacci sequence. They argue that you can use these patterns to predict future price levels. Exactly how this is done is quite complicated and you can get a detailed explanation at the Finance Overload Technical Analysis page. (Maybe they call it "overload" because it overloads lesser minds like my own and makes them ache.)
But roughly speaking, the theory argues that a stock that is undergoing a correction will retrace either 38.2% or 61.8% of its previous gain. And variations on that theme. Fibonacci levels popularly used are 0.0%, 23.6%, 38.2%, 50%, 61.8%, 100%, 161.8%, 261.8%, and 423.6%.
In the first half of the 20th Century, a trader named William Gann applied these ideas and others to develop an analytical system called Gann Analysis. And in 1948, R.N. Elliott published Nature's Law: The Secret of the Universe, in which he argued that stock market movements followed these patterns as a law of nature. His theory is popularly known as the Elliott Wave Theory.
Are they any use to you, the average investor? Does the stock market, in fact, follow patterns like a law of nature? In my opinion, no. It is an interesting theory. And it may make for interesting after-the-fact analysis of what has happened. But it is highly suspect as a predictive tool. If it were that simple to predict the movements of the stock market, everyone could become a millionaire applying those ideas. But in fact, few people if any have had that sort of success. Warren Buffett, arguably the world's most successful investor, does not use such analyses.
But it is worth knowing what Fibonacci numbers are just for fun. That way, the next time you read in the newspaper that XYZ stock has undergone a perfect 38.2% Fibonacci retracement you will know that the writer is saying "Hmmm! Isn't that interesting!" Nothing more. Nothing less. It has absolutely no predictive power about the future of that stock.
Agree? Disagree? Why not post your comments on our Hyde Park Bulletin Board!
The Fibonacci Numbers - Math Prof David Schweitzer's Fibonacci page at Holy Cross University. Lots of links.
The Fibonaci Sequence - a straight forward basic definition from the Mathematics Pages at Sel Lipi Bookstore.
Fibonaci Calculator - this page from Professor Ron Knott at the University of Surrey in England generates Fibonaci numbers to order.
Fibonaci Numbers & Nature - some of the common occurences of Fibonaci numbers in nature are related here. Again by Professor Knott.
Fibonacci Trader - software to help traders analyse stocks by their Fibonacci patterns.
What are Fibonacci Numbers - an article explaining Fibonacci numbers as they relate to investing from my About.com Daytrading colleague, Robert Rak.
If there's a concept you would like to see explained, why not email me with your suggestion.
E-mail me!
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