Gann theory

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There are a number of investors who believe that the route to success is to study the great investors of the past and mimic their methods. I am not a huge fan of this approach. Master investors are unique individuals, whose ability to adapt to changing market conditions is one key to their success. The rest of us, less talented investors, risk failing if we try and replicate their techniques.

Nonetheless, this way of operating has its followers, and none more ardent than those who follow the methods of WD Gann. Gann's approach was based around studying numbers and the relationships between them, and other influences such as astrology. It is said, although I have no real proof that of it, that many traders make decisions with a passing eye on Gann's theories.

What is beyond doubt is that Gann was a superb trader, who died a comparatively rich man in 1955 after a trading career spanning more than 50 years. His hallmark throughout his trading career was to be flexible and to use any method he could, notably stop-losses, to take the emotion out of stockmarket decision-making.

The core of Gann's theory is that there are certain long-lasting relationships in any market that govern the way prices behave. In part, he claimed, movements are based on the numerical relationships between past highs and lows in the market (especially the all-time high and all-time low) and in part dependent, in the sense of precise timing, on cyclical patterns in time linked to key numbers and even to astrological phenomena such as planetary cycles and the timing of planetary conjunctions.

Gann's written work is so abstruse that no single exponent of it uses it in precisely the same way. In practical terms, however, what Gann can offer can be reduced to some simple tests and rules involving a combination of levels in the market (or in individual stocks) at which buy and sell decisions are most likely to be profitable, provided strict trading disciplines are followed.

There are, for example, what are known as the major Gann levels.

These are often given the designations G1, G2, G3 and G4. These can be explained in the following terms. A 50% retracement from a previous all-time high might be a point at which a renewed upward movement begins. If that doesn't hold, the next key level might be a drop of 75%. Another key level is the midway point of the all-time high and low. Gann buffs call these levels, respectively the G1, G3 and G2. A quarter of the all-time high/low range added to the all time low is the G4 level.

This sounds reasonable in some ways.

Many traders work on the basis of 50% retracements (bull markets giving up halve their gains in a subsequent bear market, and so on). The problem is that Gann goes a lot further than this, introducing the idea that major fractions - a half, a third, two thirds, a quarter, one and one third, one and one half and so on - can also be used to work out likely trading patterns, as can fractions of 360 (degrees in a circle).

Experts say, for example, that if a circle or half circle is broken on the upside, the rally will usually be until the fifth circle or half circle. In other words, 180 will rally to 216, 360 to 432, 540 to 648 and so on. On the downside the same is true. So 180 will fall to144, 360 to 288, 540 to 432, and so on, these numbers being particularly powerful because they are also the square of 12 or multiples of it.

This seems arcane because there is no real behavioural or psychological underpinning for it as there is, for example, with movements related to previous highs and lows.

There is of course a lot more to it than this, and you might observe that, if you look hard enough, it is possible see patterns in any chart that satisfy one aspect of Gann theory or another. Some investors prefer investment choices that are rather more grounded in fundamentals.

Peter says

In the interests of establishing the basis of at least some of the claims made by Gann experts, I have looked in detail at the main Gann levels described in the early part of the article. I have based my calculations on closing weekly numbers for the main world indices.

Looking at the FTSE 100 patterns, for example, a couple of interesting points emerge. One is that the G1 level, a 50% retracement from an all time high, gives an index value of around 3300, very close to the level that represented the bottom of the bear market in March 2003. More recently, the G2 level (midpoint between high and low) for index movements since the start of 2000 is 5129, approximately the level reached the day after the election and from which the index has since recovered.

In the US market, the March 2009 low for the S&P 500 was very close to (in fact slightly below) the G1 and G2 levels based on the data for the all-time highs and lows, and the index has since recovered almost exactly 50% from these two numbers (which are in fact very close together, at around 768).

One can, of course, make of this what one will. I simply point out these facts so one can judge whether they are in fact simply coincidence, or evidence that there is perhaps more to Gann's ideas than the average rational analyst of fundamentals might at first sight assume.