High Probability Trading Set Ups From a Brilliant Analyst

No, is the answer if you thought the headline is geared towards myself.

I am talking about an ancient analyst. This analyst was so brilliant that Plato, Isaac Newton, Pythagoras, Johannes Kepler and many others were captivated by his research.

Yet, the contribution of this intellectual giant is dismissed by many as hocus pocus. This is actually great news for investors, because the most accurate market forecasting tools are those least known or followed.

So please, go ahead and dismiss predictive properties of Fibonacci. This will only increase the 'dark horse effect' astute investors use to formulate their opinions.

Underestimated Genius

Have you ever tried to add up Roman numbers? Rome's seven symbols - I, V, X, L, C, D, M - are mathematically challenging. It was Fibonacci who introduced the decimal system, one of the greatest mathematical discovers of all time, to Europe. Today the entire world uses 0, 1, 2, 3 ... not I, V, X, L ...

In addition to the decimal system, Fibonacci (re)discovered the Fibonacci sequence (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc.). Before we talk about the immense impact of the Fibonacci sequence on investing, let's take a look at it from the mathematical and biological point of view.

The sequence is unique because the sum of any two adjacent numbers in the sequence forms the next higher number. In addition, the ratio of any number to the next higher is approximately 0.618 (phi) and to the next lower number approximately 1.618 (except the first few numbers in the sequence).

Phi is the only number that when added to 1 yields its inverse:

1 + 0.618 = 1 ./. 0.618. The sum of any ten numbers in the sequence is divisible by 11.

Surrounded by Brilliance

Phi or the 0.618 ratio is called the Golden Ratio, Golden Mean or Golden Section. Open your eyes and you will see it and evidence of the Fibonacci sequence everywhere.

If you are sitting on the computer, you are probably typing with two hands and five fingers each. Each finger has three joints (2, 3 and 5 are all Fibonacci numbers). Your body, if it somewhat resembles an 'average' body, is divided at the navel into a golden section.

If you play piano, you know that the 8-note octave is represented by eight white and 5 black keys (again, 8 and 5 are Fibonacci numbers). If you go outside and count the petals of your favorite flower, you'll see that lilies have 3 petals, buttercups 5, delphinium 8, marigold 13 and sunflowers have 34, 55 or 89 depending on size. Sunflower seeds are arranged in a number of clockwise and anti-clockwise spirals containing 55 or 89 seeds.

I could go on and on about the integral part of the Golden Mean in life on earth, but unfortunately don't have enough space here. The image below provides some additional examples (for a detailed analysis see March 2011 ETF Profit Strategy Newsletter).

Fibonacci and Investing

Humans are visual people and are drawn to aesthetic and visually pleasing images. Humans are fascinated with the Pyramids of Giza, the Taj Mahal or the Parthenon because they are based on the Golden Mean.

Investors look at a price chart before making investment decisions. Is it absurd to assume that investors respond to Fibonacci relationships in price charts in a similar manner as they do in nature? Evidence suggests that's exactly the case.

This doesn't make Fibonacci the only acceptable forecasting tool in the world, but it's a valuable component. I use various Fibonacci projection and retracement levels to build a foundation for my forecast.

Just two interesting facts I won't show on the chart:

1) Did you know that the Dow Jones (DJI: ^DJI) peaked on August 25, 1987 at 2,746.65, less than two months before the 1987 crash? There was a major Fibonacci projection level at 2,746.70.

2) Did you know that the S&Ps (SNP: ^GSPC) 2007 peak at 1,576.09 was only a few points above the Fibonacci projection level at 1,555.04?

Fibonacci in Action

Based on valuation, sentiment, fundament and technical research I've been expecting a major market top sometime in 2011. The ideal target range for this top outlined early in the year was 1,369 - 1,382.

The April 3 ETF Profit Strategy update outlined this bluntly and without room for interpretation: 'Even though odds do not favor bearish bets the first half of April, I believe a major market top is forming. The first chart below (click here to view the chart) is an updated version of a potentially giant S&P head and shoulders pattern featured in the March 2011 newsletter. The down sloping upper trend line runs parallel to the trend line that connects the October 2002 and March 2009 lows. For the month of April this trend line will traverse through 1,377. The 78.6% Fibonacci retracement is at 1,381.5. There is a fairly strong Fibonacci projection resistance at 1,369. In terms of resistance levels, the 1,369 - 1,382 range is a strong candidate for a reversal of potentially historic proportions.'

The chart below zooms in on the S&P's performance after mid-April. Illustrated are various Fibonacci support/resistance levels (red, blue, green and purple) and yellow trend lines.

As shown by the yellow circles, the S&P topped right at the 1,369 Fibonacci resistance level, dropped to support just above the 1,255 Fibonacci level (at which time the Newsletter issued a buy signal) and was unable to stay above 1,325 (the Newsletter recommended to sell longs and go short as soon as support at 1,325 fails).

Once the S&P broke below Fibonacci support at 1,255 and the yellow trend line at around 1,265 on August 4, the ETF Profit Strategy Newsletter warned of panic selling, VIX (Chicago Options: ^VIX) expansion and outlined all the sub-1,265 Fibonacci levels to provide support/resistance guidance.

As you can see by the square boxes, the S&P responded to Fibonacci levels almost every day. Predicting what the stock market will do when in free fall (such as in August) is impossible. However, knowing the S&P's hot buttons does help. It was no coincidence that the S&P found support at 1,121 and support/resistance at 1,173 no less than eight times.

It is probably no surprise to you that my target for a multi-month bottom and an eventually rally and rally top are Fibonacci levels.

The ETF Profit Strategy Newsletter specializes on identifying important support/resistance levels and combines this information with its short, mid and long-term outlook and actionable buy/sell recommendations. Who knew that learning from (Fibonacci) history could be so effective?

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.