Can This Ancient Number Sequence Improve Your Portfolio?

Jonathan Hobbs, CFA

5 mins

Can This Ancient Number Sequence Improve Your Portfolio?
  • Leonardo Bonacci (a.k.a. Fibonacci) developed the Fibonacci sequence and ratios in the early 1200s. Traders came to love it centuries later.

  • At its simplest, the sequence begins this way: add zero and 1, and you get 1, and then add 1 and 1, and get two. Then continue, finding the next number by adding the two numbers before it, on and on, toward infinity.

  • Fibonacci numbers play out in nature all the time, and they seem to play out in trading too – possibly because many traders base their decisions on them.

Leonardo Bonacci (a.k.a. Fibonacci) developed the Fibonacci sequence and ratios in the early 1200s. Traders came to love it centuries later.

At its simplest, the sequence begins this way: add zero and 1, and you get 1, and then add 1 and 1, and get two. Then continue, finding the next number by adding the two numbers before it, on and on, toward infinity.

Fibonacci numbers play out in nature all the time, and they seem to play out in trading too – possibly because many traders base their decisions on them.

Mentioned in story

Professional traders talk a lot about Fibonacci numbers and what they reveal about when to buy or sell an investment. The levels, which mirror themselves all over the place in nature, are based on nothing more than simple math, and yet they have a habit of playing out in the market once in a while. In this guide, you’ll learn all about Fibonacci levels, and how you can factor them into your overall strategy.

What is the Fibonacci sequence?

An Italian mathematician named Leonardo Bonacci (a.k.a. Fibonacci) introduced the Fibonacci sequence to the Western world in his 1202 book, Liber Abaci.

A page from Liber Abaci describing the Fibonacci sequence. Source: Wikipedia
A page from Liber Abaci describing the Fibonacci sequence. Source: Wikipedia

The sequence is a list of numbers that follows a simple pattern: you begin by adding zero and 1, and you get 1, and then add 1 and 1, and get two. And you continue, finding the next number by adding the two numbers before it, on and on, toward infinity. Here’s the beginning of the sequence:

0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, et cetera…

Remarkably, we can see these numbers pop up all over nature: the number of petals in most flowers matches one of the above Fibonacci numbers, for example. And it’s the same pattern with branches growing on trees, which tend to grow in line with the sequence: one branch turns into two; then one of those branches splits into two again while the other hangs back.

Example of Fibonacci sequence in nature. Source: mathnasium.com
Example of Fibonacci sequence in nature. Source: mathnasium.com

Here's another interesting thing about the Fibonacci sequence: as the numbers get bigger, you can divide a number in the sequence by the number before it, and your answer will converge toward the same number – 1.618. This is what’s known as the “golden Fibonacci ratio” or what the Greeks call “phi”. On the flip side, if you divide each number by the number after it, those answers converge toward 0.618. And – wouldn't you know it – 0.618 is also the same number you get if you divide 1 by 1.618.

Using Fibonacci numbers to get the golden ratio.
Using Fibonacci numbers to get the golden ratio.

How are Fibonacci numbers used in trading?

Besides the golden ratio, you can derive a range of Fibonacci levels (Fib levels) from the sequence. If you divide one number by the number two places after it, for example, you get 0.382. Three places after it, you get 0.236…et cetera.

Traders use these different Fib levels to tell them when to buy or sell an asset. And because so many of them are looking at these same levels, they tend to work out from time to time as good points to buy or sell. There are two types of Fibonacci tools traders use in their arsenal: Fibonacci retracements and Fibonacci extensions.

1. Fibonacci retracements

Fibonacci retracements are a percentage retracement (or pullback) against the overall trend in the price of an asset. If the price of a widget goes up $100 from its previous low and then starts to drop, for example, that fall would end $61.80 lower if the price stopped at the 0.618 Fib retracement level. In other words, the price would have pulled back 61.80% of its move up (a “bullish” retracement), at which point it would find its next low and resume its uptrend. It’s the same with a move down, except the move retraces back up (a “bearish” retracement) to a key Fib level before dropping back down.

There are five key Fib retracement levels that traders pay attention to: the 0.236, 0.382, 0.5, 0.618, and 0.786. You can use the Fibonacci retracement tool on TradingView to draw these on any price chart. But here’s an example using the price of gold when it began its bear market in 2011. Twice in a row it went down, then back up to the 0.618 Fib level before keeling over again.

Bearish retracement of the gold price to the 0.618 Fibonacci level in 2011. Chart drawn with TradingView.
Bearish retracement of the gold price to the 0.618 Fibonacci level in 2011. Chart drawn with TradingView.

And here’s a bullish retracement of gold.

Bullish retracement of the gold price to the 0.618 Fibonacci level in 2008. Chart drawn with TradingView.
Bullish retracement of the gold price to the 0.618 Fibonacci level in 2008. Chart drawn with TradingView.

Let’s also look at a bearish retracement for bitcoin in 2018 and 2019.

Price of bitcoin retracing to the 0.618 Fibonacci level in 2019. Chart drawn with TradingView.
Price of bitcoin retracing to the 0.618 Fibonacci level in 2019. Chart drawn with TradingView.

And, finally, here’s a bearish retracement for the S&P 500, after its peak in December of 2021.

S&P 500 retracing to the 0.618 Fibonacci level in 2022. Chart drawn with TradingView.
S&P 500 retracing to the 0.618 Fibonacci level in 2022. Chart drawn with TradingView.

2. Fibonacci extensions

Fibonacci retracements measure the pullbacks in the opposite direction of a trend, while Fibonacci extensions measure how far the price might move in the same direction of the trend after it retraces. For example, a 1.618 Fib extension would mean the next leg up in price would have been 161.8% bigger than the one before it. Traders often use Fibonacci extension targets as potential price levels where they’ll want to sell and take profits. Here’s an example of a 1.618 Fib extension on the S&P 500.

S&P 500 retracing to the 1.618 Fibonacci extension example. Chart drawn with TradingView.
S&P 500 retracing to the 1.618 Fibonacci extension example. Chart drawn with TradingView.

Do Fibonacci levels actually work?

Stock and other asset prices move because of all sorts of factors, so Fibonacci levels should never be the be-all and end-all of your strategy. That said, Fibonacci retracements and extensions can still be a useful tool because so many traders look at them and base decisions, at least in part, on them.

You can also use Fibonacci levels to monitor your trades as you go along – one level at a time – to see how the price reacts at each level. If it moves past the 0.382 Fib, for example, you might look to the 0.5 Fib as your next point of interest to potentially buy or sell, and so on. If you do decide to use Fibonacci levels in your strategy, it’s best to use them along with other types of analysis.

Now test your knowledge with our Fibonacci quiz.

Finimize

BECOME A SMARTER INVESTOR

All the daily investing news and insights you need in one subscription.

Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

/3 Your free quarterly content is about to expire. Uncover the biggest trends and opportunities. Subscribe now for 50%. Cancel anytime.

Finimize
© Finimize Ltd. 2023. 10328011. 280 Bishopsgate, London, EC2M 4AG