Fibonacci Retracement – What the Charts are Showing

by JDH on February 20, 2016

We are all familiar with the work of Fibonacci, an Italian mathematician from Italy who died 766 years ago, who discovered what we now know as the Fibonacci sequence of numbers, where each number is the sum of the previous two numbers. Fibonacci began the sequence not with 0, 1, 1, 2, as modern mathematicians do but with 1,1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, etc.  The golden ratio is the limit of the ratio of consecutive numbers in this sequence.  It is these ratios that form the basis of the Fibonacci Retracement, which is observed by capturing two extreme points, and then dividing the vertical distance by the key Fibonacci or golden ratios of 23.6%, 38.2%, 50%, 61.8% and 100%.

Huh?

If you ignore the math, it still makes sense.  A stock will go up, and then pull back.  Invariably it will pull back to close to these Fibonacci retracement levels, which can indicate good levels to either buy or sell a security.

SPX-Feb-19-2016

As an example, here is the S&P 500 index, with the upper and lower bounds drawn at the high from the end of December, 2015, and the lows in January and February 2016.  You can click the chart to enlarge, but what is amazing is that the bounce at the start of February (the orange rectangle) took the market back up to exactly the 50% Fibonacci retracement level, at which point the market turned back down and retested the lows, again almost exactly.

The lows held, and so not surprisingly the market bounced back up to the 50% level, where it stands today.

These charts are pretty, but what is their predictive value?  What will the market do next week?

I have no idea.  It will either stay flat, or go up or down.  On Wednesday, the third big up day in a row, it closed above the 50% level, so it appeared the uptrend was on.  But it would be somewhat unusual for a bear market to have four big up days in a row, so Thursday and Friday were down days.  If we get a big pop up early in the week, it’s likely that we blast up to the 1978 level, and perhaps back to 2082.  Another down day and we are likely to see 1811 again.

Gold

Gold-Feb-19-2016

You can easily calculate Fibonacci retracement levels with any chart.

Using the gold chart’s high at the start of 2015 we can see that all of the levels were easily exceeded, so the 2015 high of 1308 is the next stop on the journey.  Of course that conclusion is obvious even without Fibonacci charts.

A more predictive picture is obtained by using the all time high of $1,932 back in 2011, which shows longer term and more robust levels.

Gold-7Years-Feb-19-2016

The key next level, long term, is $1,381, which presumably will provide a greater level of resistance.

Again we ask the obvious question: what is the predictive value of these cute numbers?

If it was a guarantee that stocks would stop and start at these levels investing would be easy.  Buy when it exceeds a level, sell when it gets close to the next one.

Of course real life does not work like that.  However, I think Fibonacci levels are a good “tool in the toolkit”, for two reasons:

First, they provide guideposts.  They allow you to see where a stock is in relation to potential turning points, which can help you decide whether to “let your profits run”, or take some cash off the table.

RGL-5years-Feb-19-2016

For example, here is a chart of RGL.TO – Royal Gold Inc., with Fibonacci retracement levels drawn back to the peak in 2012.  The 38.2% retracement level occurs at around $59.

Here is the same stock, but the chart is drawn from a lesser peak in September, 2015

RGL-1year-Feb-19-2016

In this second chart the 61.8% retracement level occurs around $59.

My point is this: whether you are looking at a long term chart, or a short term chart, key resistance levels may coincide.    Royal Gold traded as high as $62,26 on Friday, but closed the day at $59.80, which, as we can see, is an important resistance (or retracement) level.  A few days of weaknesses next week may imply a testing of lower levels.  A close for a day or two above $60 may predict an uptick to $67 or $74.  We shall see.

The second reason for having Fibonacci levels in your toolkit is that most systems of technical analysis use some form of Fibonacci retracement levels, so lots of other traders are watching these levels.  They may decide to sell as these levels approach, so knowing that others may be selling, or buying, may help explain “random” movements in stocks.

How am I using them?

Again, they are another tool in the toolkit.

On Friday, seeing that we were approaching these levels, I did covered writes on my gold stocks, like Royal Gold.  I sold slightly out of the money March call options.  If there is weakness next week, I can buy back those options at a discount, which mitigates my losses.  If the stocks blast through these resistance levels next week I will have made a mistake; I should not have covered.  But, hopefuly, I will realize the mistake and unwind the trade more quickly than I would have if I was not watching these levels.

Looking at the big picture, I see three things for 2016:

  1. Continued weaknesses in the broader markets.  We may go up this week, but this is a bear market, so my bias is to the downside.
  2. Interest rates will continue to fall, so I continue to hold  TLT – iShares 20+ Year Treasury Bond ETF, but I watch the levels to decide when to cover, and when to buy more (which I did at the end of this week).
  3. Gold has bottomed, I think, and is likely to continue much higher.

That’s the plan, and the thought process.

Thanks for reading.  More next week.