Sunday, August 1, 2010
As a student of economics and quantitative finance, I enjoy reading about the different mathematical tools that are used to optimize portfolios. Most of these algorithms and formulas require advanced and sometimes obscure mathematics, but one simple tool, used by many to calculate optimal entry and exit points for positions requires only simple elementary school arithmetic. This method is called Fibonacci Analysis, and is as criticized by opponents as it is lauded by proponents. Without taking a side on the debate, what follows is the basic method of Fibonacci Analysis.
1. Choose a security. Fibonacci Analysis works best on securities that are traded in large volumes. The reasons for this should be apparent as you read on.
2. Choose a date range to work with. Most analysts pick a range from the past three days to a week.
3. Find the high and low prices over the range. If working in Excel, you would have three columns now: Security, High, and Low.
4. Calculate the change. Find the difference between high and low. Put this in your third column of Excel.
5. Calculate the Fibonacci percentages of the change. This is where the Fibonacci part comes in. The percentages come from the percentage differences between consecutive numbers in the Fibonacci sequence (1,1,2,3,5,8,13,21,34,55,89...). The most commonly used percentages are 23.6%, 38.2%, 50%, 61.8%, 100% and 161.8% ((34-21)/55, (34-21)/34, (34-21)/21, etc). Take these percentages and multiply them by the change (found in step 4), then add to the low price. You would now have six more columns in your spreadsheet if you used the example percentages.
6. Pick an entry/exit point. The prices you calculated in step 5 show possible resistance and support points. Look at the current price of the security, find the closest points, and watch the price's behavior around those points. If it gains up to a point and then descends, it is probably a resistance point. If it falls and then bounces back from a point, it is probably a support point. Therefore, you should not immediately enter stop/limit orders based on these points, but rather watch the behavior as the security reaches these points, and decide yourself whether to buy or sell.
7. Remember that past performance does not guarantee future results. You may see many examples of Fibonacci Analysis perfectly calculating resistance and support points. Remember that these examples come from the past, and hindsight is always perfect. The present is not always so perfect, and anything from earnings reports, news story, or just the general randomness of the market can foil even the most well-calculated Fibonacci Analysis.
The rational investor wanting to read more about Fibonacci Analysis may wish to consult this article.