risk management, courtesy of Fibonacci


There is nothing arbitrary about the stop levels we use for our trades. Instead, we identify the precise level that will only be hit if the trend we are trading has ended. This level is a 61.8% retracement of the most recent trendy up leg. What is the significance of this retracement level, you ask? Not much really; it’s only the universe’s governing force.

If we start at the beginning (and I promise this is the short version), it would bring us all the way back to the 12th century. It was during that time period when a master mathematician named Leonardo di Pisa, better known as Fibonacci, was doing some serious math on the breeding habits of rabbits. Wait – what? Let me explain. Fibonacci began with a seemingly random question: ““How many pairs of rabbits will be produced in a year, beginning with a single pair, if in every month each pair bears a new pair which becomes productive from the second month on?” The better question may seem to be, who cares? We do, because this question yielded a powerful answer. The answer is a series of numbers: 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, and so on, where every number is the sum of the previous two (2+3=5, 3+5=8, and so on). This is known as the Fibonacci sequence. What makes this sequence special is the relationship between any two adjacent numbers. The farther into the sequence you go, the closer the ratio between one number and the next gets to 61.8%. You might still place this in the “random” category, until you realize that this ratio, better known as The Golden Ratio, has proven to be a balancing force throughout nature.

 

This ratio is found in the way a galaxy or a sunflower spirals. It’s found in the proportions of the human finger. It’s found in the way the Pyramids were built. It’s found in the angle that a bird approaches its prey. And for whatever reason, this ratio is found across the stock market. It’s like some kind of magnet effect – price is just drawn to a 61.8% retracement because the internal world is at peace at this level – or maybe something not quite that dramatic. Either way, we see The Golden Ratio (which is a really cool nickname for 61.8%) impact price movement every single day.

For our purposes, it serves as the perfect line in the sand. When a market is in a trend, it very rarely will retrace more than 61.8% of the trendy move that preceded the retracement. So say a big trendy up move took place, and then price stalls and begins to pull back to indicate that the trendy up move is over or at least on hiatus. At that time, we become very interested in where a 61.8% retracement of the trendy up move would occur. We know that, if the overall uptrend is still in business, price should not move below this 61.8% retracement level. If it does, it immediately opens the door to the possibility that the uptrend ended and a larger downtrend has begun. However, if the pullback stays above this retracement level, then we know that the uptrend remains dominant and will soon continue.

Still random? It may seem that way. But after you see chart after chart where price uses a 61.8% retracement as a support or resistance level, it quickly loses its mysticism and becomes an incredible tool to use in your trading arsenal. If nothing else, hopefully this sheds some light on why there are so many rabbits running around your neighborhood, and why our stop levels represent much more than just an arbitrary guess.

At TrendLizard we identify and trade the stock market’s strongest trends using Elliott Wave, and we show you exactly how to do the same. This stuff works – see for yourself!