Fibonacci, The Golden Ratio, And Stock Trading

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Stock prices ebb-and-flow according to various factors, not all of which are financial.

There's the human factors—success attracts investors, losers lose investors—and so there's a herd effect that tends to move prices higher or lower as people react to news and circumstances.

There's also mechanical factors—once buyers have bought, there are fewer buyers and stock prices sag. And so on.

This is the technical aspect of investing and it does make sense. For example, you do want to track the money flow (forget the price, money flow more or less indicates buying enthusiasm). A lot of the overbuying and overselling can be explained by this aspect of stock trading.

There are also technical measurements that are more akin to mumbo jumbo or Rorshach tests—you see patterns that you want to see. One such technical metric is the Fibonacci numbers or the Golden Ratios. Wiki it to learn more. The concept is that nature follows a certain set of ratios. The shape of the Nautilus shell, for example, embodies the ratio. And for a good reason: the proportions echoed in the Golden Ratios deliver a certain physical strength and solidity. It is found in everything from art to architecture.

Some investors believe that these ratios can also apply to stock prices. Which seems strangehow could physical ratios map to investments and in particular financial behaviors. Believe it or not, they can and do.

Shopping is one classic example of human financial behavior. Think about the ratios used during a sale. We often see stickers telling us to take 25%. Over time, the sale price drops: take 50% off! And at the most extreme, take 70% off.

These figures correspond neatly to Fibonnaci numbers. The Fibonacci numbers say that when a stock is retracing (aka falling), it hits several ratios of the peak price: 61.8%, 50%, 31.8%, and 23.6%.

If the stock were on sale, those figures would translate to discounts of 28% (100%-61.8%), 50%, 68%, and even 76%. Very, very close to what we encounter in real life when sales are underway.

In other words, there seems to be a human perception at work where we are stimulated to act when we encounter certain proportions of change. We know that the human beast is wired to act—fight or flight. It's just a little hard to imagine that there might be actual formulas that dictate how far we will run. (A lion is chasing me: how much distance do I need to be in order to feel safe?)

In the stock market, technical traders applying the Fibonacci ratios would say that these become resistance lines. The stock price will move to these levels and then bounce around. The thinking is that prices are drawn to these points. And when they hit the resistance level and continue to drop, then the stock price tends to gravitate to the next resistance point and that's defined by the next Fibonacci number.

Too neat and pat? Well, it just happened with Bitcoin.

Start with the peak price of $19,870. The Fibonacci numbers tell us the resistance levels are:

• 61.8% = $12,280
• 50% = $9,935
• 31.8% = $7,590
• 23.6% = $4,690

And here's what just happened. On Dec 16th, Bitcoin peaked and then steadily dropped. On Dec. 30th it fell to $11,962 and then promptly climbed back to $17,152

If you buy into the Fibonacci framework of thinking, then you would say that the stock price bounced off the first resistance level (the difference between the predicted $12,280 and the actual $11,962 is just noise).

Under the Fibo rules, if the price dropped again and remained below that $12.3K level, then it would next drop to $9,935 or thereabouts, before bouncing again. And that's exactly what it did.

On Jan 16th, it fell below $12,000 and then promptly slid to $9,981—the next Fibo resistance level. And then it bounced up again (again, the predicted resistance point was $9,935 and the actual $9,981 is just noise).

Twice in a row it would seem that the Fibo numbers were predicting the price destinations.

Here again, the theory is that with the resistance at $9.9K (as defined by the Fibo numbers), the next resistance would be $7,590. So let’s look at what happened. For almost a week, BTC held at $11,000. But the price did not recover the $12,280 level—implying that it would fall back down again and re-test $9,935.

And BOOM! It fell below this level and promptly marched down on Friday to $7,760. Fibo said $7,590, but what's $170 difference between friends.

It recovered but because it stayed well below the $9.9K level, it was destined to re-test $7.6K. And, sure enough, on Feb 5th it is doing that.

From a behavioral standpoint, investors are being offered a deal: BTC is on sale at 61% off the recent peak price. If you liked it at 50% off, why wouldn't you add to your position at 61% off?

Because that's how investors—aka shoppers—think. But I think there’s a lot more downside still, and that’s what the resistance points are indicating.

Is this a deal? Even at $7K BTC is up 7x over the year. So it's hardly a bargain.

Never mind the emotional or behavioral aspects of buying an asset at a perceived discount. Consider now the practical limits: where is the new money?

Recall that a lot of money piled into BTC the last few months. They no longer have money to put into the pot. Worse, there is a margin squeeze which is adding to selling pressure: many buyers used leverage.

Plus, go back to fundamentals. Is Bitcoin for transactions or a storage of value? BTC was used in the gray economy for buying goods and services. For example, Craigslist has a filter on the FOR SALE section where buyers can indicate that they take cryptocurrency. So there is a value of sorts.

But the bulk of the price surge comes from BTC as an alternative to dollars and gold. And that makes it hugely emotional and driven by speculation.

Which means that a blowoff will remove almost all of the speculative surge. Which means that BTC has a floor of $1,200 – it’s transactional value.

As retail money came in, smart money found an exit. Starting Dec 18th, the CME allowed bitcoin futures. With just 35% margin, put options could be purchased.

Bitcoin begins to slide that same day, when investors became able to start shorting it. Cause, meet effect.

What Happens Next?

BTC will drop to $4,700. That assumes that $7,000 won’t hold. And that’s not a cause for panic—BTC was $1,000 last January, so that’s still a handsome profit. And I believe that there are a lot of people who will sit tight. That end-of-year surge caught a lot of people by surprise. They didn’t sell all summer when BTC was $4000, so why sell now?

But a lot of people are now going to be forced to sell, and that’s the pressure into tax season.