By David Adams – Is there any real value in predictive statistics that traders seem to pull out of thin air? The proponents of the random market theory (efficient market theory and it’s many variations) would say “absolutely not.” But the army of Fibonacci proponents and a sea of floor traders who use them beg to differ, because they have watched prices stop on Fibonacci numbers time after time. The question, then, is a simple one; Someone has to be right and someone has to be wrong, why do the market adherents in each camp disagree on something so fundamental?
Do you find it ironic that we understand the more about the subatomic world of molecules than we know about how the market and it’s functions? Some of the best and brightest academics claim there is no predictive ability in using Fibonacci trading. Why? The science of predictive indicators does not pass the litmus test of scientific legitimacy. If you have ever traded Fibonacci numbers, can you tell me whether the market will turn on 38% retracement, 50% retracement, 61.8 retracement? That’s the problem academics have with these systems, there are no empirical facts. Yet many traders swear by them and are very successful in trading them profitably.
Welcome to the world of day trading. It’s a world where traders use systems that are wildly varied and the results are unpredictable. Because the functions of the market are not well understood, as evidenced by the universe of varying opinions on market price action, you will find a plethora of divergent theories and traders who vociferously defend the system they trade to the exclusion of other trading systems. Further, you are unlikely to find two traders who trade identically, even if their investment philosophy is identical.
Let’s start with the Fibonacci numbers. The ratio used to calculate this set of numbers is 1.618 and it stays constant throughout the sequence. Originally identified by mathematician Leonardo Fibonacci in the thirteenth century, their popularity has increased exponentially in day trading. The question is whether they work, and why do they work. Anyone who has traded Fibonacci numbers comes to realize that the market often pauses, sometimes turns, and often blasts right through the sequence of Fibonacci retracements. There is no denying the numbers are relevant, and traders pay attention to them.
But why does the market stop and start so often on these numbers? In trading we don’t necessarily worry about the “why” questions, if something works or has predictive value it is used. You cannot necessarily predict which Fibonacci number the market will choose to honor. On the other hand, many people identify market high and possible lows using Fibonacci ratios, but any trader could identify these point using the alternate method of support and resistance. Yet this support and resistance often occurs right at the 50% or 61.8% Fibonacci levels. Sheesh…..
It is my opinion that Fibonacci numbers work just fine, but the reason they work is because so many technical traders use the system. When the market makes a move from trough to peak, most technical traders will immediately add the Fibonacci retracements to the entire move, and hence the system becomes a self fulfilling prophecy. And that’s okay. Many true Fibonacci traders take offense to this explanation, and claim there is relevance in the ratio. Perhaps there is, but I’m not buying that explanation. As a chaos theory adherent, I feel the only scientifically relevant explanation is the self-fulfilling prophecy argument. The Fib people point to ancient architecture and a wide variety of natural phenomena that use the Fibonacci sequence. It’s true, lots of ancients architects and unexplained phenomena have relevance in their respective fields, but I cannot connect the dots. Which is to say, “yes there are Fibonacci numbers all about, but what does that have to do with investing?” The answer is a resounding “nothing at all.”
But I still use Fibonacci numbers in my trading…
As a day trader, my job requires me to take profitable trades. Whether the Fibonacci sequence is scientifically verifiable is irrelevant to me, as I am only concerned with profitable trades. I cannot recommend using only Fibonacci ratios in your trading. However, I always trace in the retracements after a significant market move, up or down. You would be surprised how often the market honors them, too. I especially like to trade the Fibonacci when it has already stopped and turned on a specific number, as this establishes real legitimacy for this point on the chart. Then I can go to work trading, based on the info the Fibonacci has imparted.
So there you have it, the reason the Fibonacci ratios work is unclear, and I am unwilling to bestow mythic credibility based on the history of the ratio. On the other hand, there is no denying the market pays attention to these numbers. Whether I believe they are a self-fulfilling prophecy is irrelevant, because as traders we only deal in profitable trades and growing account balances. The “why” just doesn’t matter.
About the Author
Many academics cannot find relevance in the Fibonacci sequence and give it short shrift, yet many Fibonacci traders swear by the system. I take a look at the facts of the system and try to sort through how the Fibonacci works, and why it works.
