Fibonacci or Why 1.618 is GREAT!

My last post introduced two hidden laws of the markets: the zero-sum game and the boom-bust proportionality cycle of 18 years. It even offered a striking prediction: economic stagnation until 2017!!

As promised here is a new law: Fibonacci.

What is Fibonacci? By the end of this post, you will be thinking 'What isn't Fibonacci?!,' but here we go:

This ear is ideal, because it follows a
 Fibonacci Spiral (Theabodeofpeace.com)

Discovered by Leonardo of Pisa (known then as Fibonacci), the mathematical sequence involves starting with 1 and then adding the 2 preceding numbers:

(0),1,1,2,3,5,8,13,21,34,55,89,144, etc.

This sequence gradually forms the ratio: Last #/Pentultimate # = 1.618. (144/89) = 1.6179.

Mona Lisa - Ideally 'Fibbed'
(wikispaces.com Fibonacci+Sequence)

In Dan Brown's wildly popular novel The Da Vinci Code, this ratio was referred to as The Golden Ratio and even the Divine Proportion. Why all the fuss?

The number 1.618 is so important it has been given the Greek letter ɸ (phi) in mathematics. ɸ permeates through our world: from the design of the body to that of Notre Dame to the very shape of our galaxy. Look closely at your finger. Notice how the distance between each joint seems to be proportionally larger than the last. If you care to measure, you will find that your finger follows a fibonacci sequence. The distance from the tip of your finger to the first knuckle is roughly 2cm. Going further, the distance from the first knuckle to the next is 3cm. From there to the third knuckle is 5cm! From there till the wrist is roughly 8cm. 2,3,5,8.... Fibonacci!

Yes, you're a formula - get over it!
(hy-se-sy-se.com)

Yet this goes further! The distance between the finger tip and the wrist and the wrist to the elbow forms a ratio of 1/1.618! Similar relationships exist between:

• Length and width of face
• Distance between the lips and eyebrows and length of nose
• Length of mouth and width of nose
• Distance between shoulder line and top of head and head length!

Beyond the Body, Fibonacci permeates throughout Nature:



Fib Flower: First layer of petals - 8; Second layer - 5
Reverse Fib Sequence
(jwilson.coe.uga.edu)



The Common Plant: Grows with the Fib
(jwilson.coe.uga.edu)



As can be seen, price seemed to move within defined proportions. Some traders are religious about 'Fib' trading, but in my humble opinion, a lot of it is hindsight. If you look at the following S&P500 chart showing the price movement of US shares during the 'credit crunch,' you can see that, indeed the price moved exactly to the 61.8% reversal point, a key figure watched by fib traders. However, hindsight is 20/20. Traders watch other Fib levels, such as the 38.2% level and the 161.8% level. Which one traders should use is hard to tell.





But how can we use this insight to our advantage financially? Financial technicians - traders who use mathematical formulae to make decisions - have discovered that this pervasive ratio can be used to forecast the price movements of various financial instruments. The idea is to measure a major movement - for example the the decline in the S&P500 during 2007-2008 - and then multiply the result by fibonacci ratios. The resulting numbers will be the most likely ends of the next price movement. The following video shows a trader explaining this phenomenon:

(LeverageFX.com) 

Indeed, Fib traders often include the 50% level into their screens, which isn't part of Fibonacci at all! However, it is psychologically important. Again using the S&P500, this time showing the market recovering from the 3-year slump from 2000-2003, we can see that it rises exactly 50% of the distance that it had just fallen!



 If you can take anything away from this post, I hope that you have learnt to see the world in a different way, 1.618 to be exact! The universe seems to move in a defined pattern, with humans, plants even the galaxy itself reliant on the Golden Mean!

Till next time, when I discuss why the US government thinks you're SCUM (and why their probably right!)