Understanding Fibonacci Retracement

Getting in sync with the natural rhythms of the market is the ultimate goal of market-timing investors. Fortunately, there’s a popular analysis tool that helps me do just that.

It’s based on the work of a brilliant 12th century mathematician named Leonardo Pisa. Basically, Pisa described the natural mathematical “order” inherent in a wide range of systems.

To perhaps over-simplify his work, one premise of his was that organic systems can be roughly divided into segments of two-thirds and one-thirds. Specifically, Pisa’s work was based on Fibonacci numbers, sequences and ratios. Over the years, these relationships have been adopted by thousands of investors looking to get in tune with the market’s wave-like moves up and down.

Let me show you one example of Fibonacci numbers in action. Take a look at this chart…

See image larger

By mid-2009 it became clear that the stock market recovery was “game on.” Without taking a breath, the S&P 500 shot 82% higher in just 13 months. That’s a move that is simply unsustainable. To Harry’s point – the market has to exhale.

Under these circumstances, a wise tactic is to wait for a pullback, then buy when the uptrend resumes. Fibonacci retracement levels give traders a useful way of estimating just how deep the pullback will be.

The rule of thumb is that a pullback will retrace a minimum of 38.2% – about one-third – of the predominant trend. As you can see, this happened in April 2010 when the market started losing steam. It was due for an exhale and was sure to retrace part of the strong up trend.

The question was – how much?

Anyone following Fibonacci retracement knew the best time to go long again. In July, the S&P hit the 38.2% Fibonacci retracement level and immediately turnrned higher. After that, the uptrend was back on and the S&P gained another 36% in 10 months.

This is a classic example of the market’s natural rhythm and a great way to profit from being in tune with it.

If you haven’t done so already read the Survive & Prosper issue on “What Drives Our Economy?”