|(Editor's note: This article was created on April 1, 2001.)|
As you examine articles that attribute their approach to Gann, common themes recur: retracement zones and trends. Retracement zones are characterized by price swings, and trend changes are initiated with price swings. When will the trend turn direction or when will the price go into a continuation pattern and then resume its current trend?
What is the most common continuation pattern encountered while in a trend? The answer is a wedge. The top chart of Figure 1 shows an idealized price history going through a peak followed by a downtrend. Given that you want to characterize a wedge continuation pattern, what will you use? As the top chart shows, you will use a pair of lines that slant upwards (to form a rising wedge). In order to create the pair of lines that show the uptrend resistance, which will form the wedge, you have to move the origin of the Gann angle down the vertical line because you need two lines, each with a different origin. By sliding the origin for the Gann angle down the vertical line, you are doing nothing more than saying this equity is still going down, but that's exactly what a wedge is saying; the trend is still down.
The general rule is that a rising wedge (formation shown in Figure 1) is bearish and a falling wedge is bullish. A succession of falling wedges are created by Gann angles created at successively higher origins, implying rising price, and a succession of rising wedges are created by successively lower origins, implying falling price.
|The other theme that recurs is 50% retracement. Gann is reported to have said that 45 degrees was the most important angle. Recall that Gann used square grids. Suppose you create a square grid of 8 x 8. Now draw a line from the lower left corner to the upper right corner. The line is at 45 degrees. Next draw a line between the other two corners, upper left down to lower right. Another 45 degree line. Where do they intersect? In the middle, at 50%. |
|Figure 1: Idealized downtrend price behavior (top chart) with wedge continuation patterns, QQQ (weekly data) analyzed in a similar fashion (middle chart) and QQQ (daily data) analyzed using a 50% retracement (bottom chart).|
|Graphic provided by: MetaStock.|
|Graphic provided by: Data vendor: eSignal<.|
|To create the bottom chart I have not shown the Gann angles, but have attempted to analyze QQQ using Gann-like techniques. I have noticed for some time now the daily downtrend price behavior of QQQ contained wedges. In view of the way that Gann might have approached the problem, this means creating a series of Gann angle origins, with the origins sliding down a vertical bar going through the September 1 peak. What I have noticed is a downtrend, interrupted by a series of wedge continuation patterns, and then a downtrend that is still continuing.|
The start and end of each wedge could be confirmed by using swing points. I used ZigZag with an 8% filter (recall that Gann preferred two-day changes - which is a way of filtering out noisy little dips, not unlike point and figure techniques to only plot Xs and Os after a predetermined amount of change). ZigZag is a technique that allows you to filter a change in direction based on either percentage or point change.
At 5% I was seeing every little up and down in price, as well as those in the bottom chart of Figure 1. Much to my comfort the way I had hand drawn the wedges matched with the swing points --- so you don't need ZigZag --- although I admit it's a handy little tool. By the way 5% ZigZag shows only five downswings in the uptrend from October 1999 to the March 2000 peak, and shows 14 upswings when applied to the downtrend from September 1, 2000 to the current date. The fact that an 8% filter still shows significant price patterns for a downtrend, while 5% is needed for an uptrend only confirms that prices move faster for a downtrend than for an uptrend.
Next I drew support and resistance lines to match the tops and bottoms and of the wedges - seen as blue dashed lines on the bottom chart. I wanted to see the bottom of the wedge above act as resistance to the uptrend of the wedge below - and it did. I wanted to confirm that price was in fact going through zones of resistance and support, but maybe a more appropriate phrase would be zones of distribution. Each wedge is characterized by buying on decreasing volume - in other words, a weak accumulation. The downtrend is resumed with selling on heavier volume - distribution. I checked the volume at the swing points that are the wedge "ends" and they are marked by lowered volume.
What to do now? I don't try to pick downtrend bottoms because I think it's guesswork. Gann also didn't try to find bottoms either, so it is not surprising his techniques didn't either. If Gann couldn't, or didn't want to, figure out a way why should any of us? But curiosity has gotten the better of me. What did they say about curiosity and the cat? So for what it's worth, and this is a bit scary, looking at the area where the wedges occurred was definitely a period where the market was trying, without much enthusiasm, to just say no to more downtrend. It failed. So I went through the drill. I declared a large area as a distribution zone. It marks the 50% point. So is the bottom at QQQ=36? If it is, this is not going to be pretty.
To see if I could confirm this bottom I brought up the QQQ weekly data, which resulted in the middle chart. To create the middle chart I use Gann angles to define a rising wedge. I used swing points defined by ZigZag with a 5% filter to help see the wedge. The bottom of the wedge suggests an origin point on a vertical line drawn through the peak on September 1, 2000. Drawing a 1x1 from that same origin point suggests support at QQQ=31.5. Almost the same story, only worse.
Gann was an impressive trader. Even if I only understand some of his techniques, I can certainly agree with his trading rules. If you have been trading for a while, these rules will jump out at you - they are that good. If you are just starting, do your best to incorporate them. I have incorporated my comments in parenthesis.
GANN'S 28 TRADING RULES
(Sidebar - "The Gann Method", John J. Blasic, Technical Analysis of Stocks and Commodities, June 1992)
1. Never risk more than 10% of your trading capital in a single trade. (Good risk management rule.)
2. Always use stop-loss orders. (Good risk management rule.)
3. Never overtrade. (Avoid getting whipsawed - don't try to catch up.)
4. Never let a profit run into a loss. (Don't try to hit the top if long, or the bottom if short.)
5. Don't enter a trade if you are unsure of the trend. (Never buck the trend. If a trend has developed and you are trading trends then make sure through setup and entry the trend is established. Going long in a downtrend or bear market is a way to see your capital get eaten away. Conversely going short in an uptrend or bull market will also see your capital get eaten away.)
6. When in doubt, get out, and don't get in when in doubt. (Patience, patience, patience - it will pay to be patient and sure. I have learned this the hard way.)
7. Only trade active markets. (Never short a dull market, and pile of other rules come from this.)
8. Distribute your risk equally among different markets. (Asset allocation still works.)
9. Never limit your orders. Trade at the market. (In a trend trading system, limit orders do not confirm the direction of the market for entry - they are countertrend because they want a better price, which would be against the trend. If you are trading support and resistance in a trading channel, then give this a shot.)
10. Don't close trades without a good reason. (Know your exit criteria. Exit because your trading systems says you should and not your intuition. Non-professionals often get out too early because their intuition says to get out.)
11. Extra monies from successful trades should be placed in a separate account. (Don't expose your profits to the same winner of the moment.)
12. Never trade to scalp a profit. (Scalpers can to do this through Nasdaq, but at Gann's time this was not available. You also have to worry about slippage in a big way.)
13. Never average a loss. (Your biggest drawdown is your biggest worry.)
14. Never get out of the market because you have lost patience or get in because you are anxious from waiting. (Gee - does he have to tell me twice? Hmmmm.)
15. Avoid taking small profits and large losses. (Know your risk- to-reward ratio and use stop-loss orders. For a trend trading system stop limit orders are a way to enter with a confirmation of trend direction.)
16. Never cancel a stop-loss after you have placed the trade. (One in the hand is worth two in the bush. Always have a stop-loss in place. Don't remove a stop-loss before you place another.)
17. Avoid getting in and out of the market too often. (Hmmmm - this is the second time you've told me. I wonder if you are hitting me up again about being patient, in which case this makes the fourth time.)
18. Be willing to make money from both sides of the market. (Learn how to short.)
19. Never buy or sell just because the price is low or high. (Fundamentalists eat your heart out - sorry, I just couldn't resist - probably goes to my problem with being patient.)
20. Pyramiding should be accomplished once it has crossed resistance levels and broken zones of distribution. (Gann recognized that price swings seen in trend channels are a series of accumulation and distribution zones - they are most easily seen as patterns, such as wedges. "Trend changes most often occur outside the retracement zone after the initial support resistance levels are tested" ("The Gann Method", John J. Blasic). Retracement zone and consolidation zone are used interchangeably in this article. It would appear that QQQ has passed through its retracement zone and now we are waiting for the bottom.)
21. Pyramid issues that have a strong trend. (Pyramiding uses the unrealized profits in your margin account to buy even more - thus leveraging yourself while riding the trend.)
22. Never hedge a losing position. (For example - trying to trade long in a bear market is a good way to see your money slowly but surely eaten away by hedging via protective stops and buying options - the better choices for a bear market are (1) buying bonds - Greenspan must really like the bond traders- (2) selling calls (3) buying puts (4) shorting.)
23. Never change your position without a good reason. (Watch out for three-day reversals - use swing points to assure that the trend has changed - in other words, don't switch from long to short unless you have backtested data that says you should switch.)
24. Avoid trading after long periods of success or failure. (Successes can make you overconfident and stop using a system, while losses can make you hesitant to pull the trigger when you should.)
25. Don't try to guess tops or bottoms. (Guessing is gambling - Vegas will pay better than the market. Gann's techniques were aimed at support and resistance relative to trends, not sideways trading channels with chop where support and resistance pick the tops and bottoms of the chop within the channel.)
26. Don't follow a blind man's advice. (If someone tells you about a good trade opportunity - ask them why it's good - those who see, usually have a number of reasons - as part of seeing is seeing a lot; ask them what the setup and entry is for example.)
27. Reduce trading after the first loss; never increase. (If you have a trend trading system that contains setup and entry conditions and you take a loss, it could be that market is going into chop. A trend trading system will lag price moves and your losses will grow faster if you don't pull back on the amount you trade or the number of times you trade. Since Gann didn't use daily charts he avoided buying on dips and thus reduced the number of trades by avoiding trading on dips.)
28. Avoid getting in wrong and out wrong; or getting in right and out wrong. This is making a double mistake. (Did you notice he didn't say that getting in wrong and getting out right was a double mistake - paying too much for something can be corrected by waiting for the price to return higher - and selling too low can be corrected by waiting for the price to go lower - still each is a mistake just not as bad as the first pair.)
Professional traders are following the above rules. If you aren't, then you need to consider more of an investment slant versus trading for a living. If you are going to have an edge you need to do or at least understand all of the above and then some more.
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