For us at Cestrian, we like using the patterns provided by the Fibonacci sequence. We wrote recently about a specific kind of Fibonacci level that is proving effective for us - you can read that note here
- the note includes links to the Investopedia page which will help you if you are new to Fibonaccis or you have some familiarity with them but they make your head hurt so you stopped bothering. (Try again. It’s not that hard, really. People want you to think it’s hard. It’s not.)
We like the Fibonacci patterns because they are less subjective than most, which mean less likelihood of seeing things one wants to see. This is because the distance between the Fibonacci levels on the chart is defined by the Fibonacci sequence of numbers itself - you don’t have to guess where to put them. And those levels are themselves determined by reference to the ‘golden ratio’ - 1:1.618
- seemingly a fundamental constant of nature and indeed apparently a building block of the emotion underpinning the fear/greed motivation. It’s the case that if you overlay a Fibonacci sequence on most any liquid security, you can find that the security respects the levels as support and resistance at various times. Whether this magic is a result of it being a self-fulfilling prophecy - folks just trading to the sequence on purpose - or whether it’s a kind of codified method of understanding trader emotion - we don’t know. If we’re honest we think a little of both.
Self-fulfilling, because, for instance, most people know that a 78.6% retracement of a prior high is a brutal correction that can likely be bought safely. That a 3.618 extension of a trend, projected from a reversal trough, is a sugar high that should probably be sold.
But also genuinely insightful, because if you start to project extensions and retracements in a non-textbook way, you can also see securities respect the levels as support and resistance levels, and since your method of choice is not in any textbooks, there must be something about those retracements and extensions which map to the fear and greed that runs in each and every trader’s veins and which as a result runs in the code of the algorithms that traders write.
Here’s how we use Fibonaccis in our staff personal account work and the stock ideas in our various newsletters and other pay services.
- We fundamentally and unshakably see the truth that the levels within any correctly-drawn Fibonacci sequence has explanatory power for historic securities movements, and predictive power for future movements. Specifically, the prices at which securities will find local areas of support and resistance. Not perfectly predictive, rather, capable of predicting highly probable events. Probably stock X will pause at a 100% extension. Probably Y will reverse at the 0.786 retracement. And so on.
- We use retracement - pullback - measurements to consider when we might reasonably buy into stocks we like at advantageous points, whether they be new names or adding to existing holdings. Just today we added to Cloudflare ($NET) in staff personal accounts because it bounced off of a 0.618 retracement from the prior run up. (Last week we sold the $NET puts with a $160 and $120 strike that we had bought during the run-up. Sold too early as it turned out, though we sold profitably. Those put strikes were selected based on the same Fib sequences we used to judge today’s buy. $NET by the way has been a huge winner in our pay services).
- We use extension - run-up- measurements to consider when we might take some or all profits on a name. Some profits if it’s a stock we want to own long term; all profits if it was purely a trade.
- We use the levels below where we buy as actual or notional stop-loss triggers.
If you learn to use these simple tools - they sound complicated but with practice, they aren’t - then armed with your charting website, you can go hunting - retracement and extension hunting.
The true value of that Golden Ratio basis is that as long as you pick an important start point from which to measure your retracement or extension, the sequence does seem to be powerful. And that in our view comes down to “market memory” ie. trader emotion. You can project extensions from recent highs as well as from retracement lows, and still get useful results. The only judgment required is, pick a sensible start point - usually when a security gaps up or down, or strikes a marked new low or high; and then modify the timeframe you are looking for until you find the sequence gives you some explanatory power over previous price action. Assuming a reasonably long timeframe - say months or more - you can then have some belief in the predictive power too.
Here’s HubSpot ($HUBS) for instance. Started a run up in mid 2017; peaked right before the Covid crash; bottomed out almost precisely at the 0.786 retracement. And for the avoidance of doubt, yes, we specifically chose the start point of this chart so that the Covid low was a 0.786 retracement. Arbitrary you might say - drawing any old lines. But the reason
we did that is because we think that projecting - extending - the trend from such a point has predictive power. And lo, did the stock hit the 4.236 extension when started from the prior high .. and yea verily did we sell down the stock in staff personal accounts having first declared in our real-time Growth Investor Pro
service that we were doing so. Which proved wise, since the stock is now retracing its steps - currently the stock sits at the 0.236 retracement of the move up from the Covid crisis lows. (Full page chart is here