A few weeks back, I kicked off the Intelligent Investor Series as part of my weekly commentaries. Th...
Gann’s Chart-Reading Technique
05/03/2010 10:33 am EST
This free chapter is from Gann Simplified, by Cliff Droke:
Gann was a big believer in using financial charts to judge the soundness of common stocks and commodities. “All of the information that affects the future price of (stocks and commodities) is contained in its fluctuations and you need nothing more than its record of prices,” he used to say. Most of his work was based around various ways of interpreting the chart, and without it, his forecasting success would have been largely impossible.
The fundamental premise behind the use of charts in trying to predict price trends is the old maxim that “history repeats.” Gann was fond of quoting the passage of Ecclesiastes in the Bible, which says, “The thing that hath been, it is that which shall be; and that which is done, is that which shall be done; and there is no new thing under the sun.”
“This shows that history is but a repetition of the past and that charts are the only guide we have of what stocks have done and by which we may determine what they will do,” Gann would say.
Along with the price indications provided by the chart, Gann always paid special attention to the trading volume behind the price movements. “The volume of sales on each individual stock shows the percentage that is being bought and sold. That is why the tape and price fluctuations tell the truth, provided one interprets the tape correctly.” Gann pointed out that a stock cannot be distributed or accumulated without a large volume of sales. Someone must buy and sell a large percent of the capital stock near the bottom or top in order to cause a big move in either direction. Therefore, Gann urged traders to study volume closely, along with the time required to sell a large amount of stock and the number of points which it moves up or down while the volume of sales is accumulating. “Study the volume of sales at each important bottom and top and consider the number of shares outstanding in each stock,” was his frequent admonition. “This will help you to determine whether buying is better than selling, or not.”
One of Gann’s rules concerning volume was that if a stock has a very large volume of sales in a day and has made a very narrow range in fluctuations, do not buy or sell until it shows a wider range of fluctuations, and go with the trend whichever way the move starts. Gann urged his students to keep up a daily, weekly, monthly and yearly chart showing the highs and lows for each respective time frame. By doing this, he said, a trader or investor can obtain an accurate picture of the overall position—strong or weak—of the stock he is following. “This is the proper way to read the stock tape,” he said.
Gann provided the example of U.S. Steel—a popular stock in his day and one of his favorites to trade in—to illustrate one of his rules concerning volume. “Suppose US Steel has advanced 20 or 30 points, and it reaches a level where there are 200,000 shares in one day, but the stock only gains one point. The next day there are 200,000 shares and it makes no gain. This is plain enough that at this point the supply of stock exceeds the demand, or at least that buyers are able to get all the stock they want without bidding prices up. In a case of this kind, the wise thing to do is to sell out, watch and wait. If all the stock at this level is absorbed after a reasonable length of time, and it moves up to new high prices, it will then, of course, indicate still higher.
“In a big bull market, when stocks reach the distributing zone, they will fluctuate over a wide range and the volume of sales will run several times the total outstanding capital stock. For instance: In the latter part of 1919 and spring of 1920, Baldwin Locomotive sales ran from 300,000 to 500,000 shares per week, while the stock was fluctuating between 130 and 156. This was when distribution was taking place, and the public was full of hope and buying regardless of price.”
“After that, a long decline started and Baldwin reacted to 623/8 during the week ending June 25, 1921. It was down 93 points from the high of 1919. During the last week of the decline, it went down from 70 to 623/8, over seven points, and the total sales for the week were less than 110,000, which showed that liquidation had about run its course and that there was very little stock pressing for sale. The amount of sales at this time, in one week, were about half of the capital stock and probably about as much as the floating supply, while when the stock was nearly 100 points higher, the capital stock was changing hands about twice each week.”
The normal pattern then ensued as Baldwin began to rally from the June 1921 lows of 623/8 on light volume. This indicated that there were not many shares for sale and that the stock had passed from the weak hands to strong ones. Therefore it was very easy to rally this stock. The stock advanced to a high of 142 in October 1922. At this point another distribution phase took place. Observing many examples such as this reinforced Gann’s view that volume was one of the key ingredients to trading success.
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Gann taught that by studying past history and knowing that the future is but a repetition of the past, one can determine the cause according to the time and conditions. “The average man’s memory is too short,” Gann wrote. “He only remembers what he wants to remember or what suits his hopes and fears. He depends too much on others and does not think for himself. Therefore, he should keep a record, graph or picture of past market movements to remind him that what has happened in the past can and will happen in the future, and should not allow his enthusiasm to get the better of his judgment and buy on hope, thinking that there will never be another panic.”
Gann provided several useful rules for using chart analysis to determine when a bear market had ended. He taught that a bear campaign must run three to four sections before the bottom is reached. “Look over your charts and you will find that each group of stocks and each individual stock, when it starts on the down trend, runs out three to four sections. First, it has a sharp decline; then rallies and is distributed; then has another decline; hesitates, rallies and then has another decline; hesitates again and then has a final big break, or one we call the cleanout, when investors and everybody get scared and decide that stocks are never going up again and sell everything. When this final cleanout comes, that is the time to buy for the long pull for another bull campaign.”
The Best Charts to Use
An extremely important distinction Gann made was in which kinds of charts to use. For instance, Gann did not believe in using space charts, also known as “point and figure” charts, because they do not contain the critical time element, instead displaying price only. The other type of chart that Gann said was most likely to fool traders, by producing false moves, is the daily bar chart. The weak point with these charts is the fact that they show the minor moves, which Gann likened to the ripples in the ocean caused by a pebble. They do not disturb or determine the big move or main trend. Most traders use this kind of chart.
Gann believed that the best charts to use are the weekly, monthly and yearly charts. Gann liked using longer-term charts because they show more time, and the more time a chart shows, the more reliable are its indications. “The weekly and daily high and low charts are valuable when the markets are very active and are good to use on very high-priced stocks at the time they are culminating or in the final grand rush, because the daily and weekly will show the first change in trend,” he wrote. “They are better to use at the tops of fast moves than they are at the bottom. However, when markets have a quick, sharp, panicky decline, then the daily and weekly charts will help, but the best guides in long pull trading and determining the main trend are the yearly and monthly high and low charts.”
Later in his life, Gann urged his students to also use quarterly charts in their attempts at determining market trends. In one of the last books he wrote, How to Make Profits in Commodities (1951), Gann had this to say about the quarterly chart:
“The more time period used in a chart, the more important it is for determining a change in trend. By a quarterly chart, or a seasonal chart, we mean a chart using the four time periods or seasons of the year. We use the first three months of the year—January, February, and March. Then we use the high and low prices of wheat, soybeans, or other commodities for these three months, the winter quarter. Next, we use April, May, and June to complete the spring quarter. After that, July, August, and September for the summer quarter. Last, October, November, and December for the fall quarter. This makes four periods, of three months each, in each year. Study a quarterly chart carefully, and you will see how these quarterly periods show when an important change in trend takes place. Observe how many times, after a prolonged advance or decline, the first time prices break the bottom of a previous quarter it indicates a change in trend, and a bear market starts. The first time the prices of one quarter exceed the high levels of the previous quarter, it nearly always indicates a change in trend, and a bull market follows. If you will study any quarterly chart carefully and note the position of wheat, or any other commodity, in connection with the monthly high and low chart, and the weekly high and low chart, you will find it very helpful in determining a change in the main trend. I advise keeping up a quarterly chart on each individual commodity that you trade in.”
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Gann laid down several rules for studying the daily, weekly, and monthly charts and determining their respective positions. He advised watching the action of the daily moves in the first, second, third and fourth stage. If a stock begins an advance, then hesitates and begins a sideways or lateral movement and goes through resistance levels on the upside, he advised watching how it acts when it hesitates and stops the second, third and fourth times. When it reaches the third or fourth move up, he advised watching for a change in trend, as this represents the culmination period of the move. The same rule applies to the first, second and third moves on the weekly and monthly charts. It also applies to the major as well as the minor swings. According to Gann, when a market begins declining or an individual stock starts down, it usually makes two, three and four movements before it reaches final bottom. If the trend is going to reverse, it will only make the first and second decline and then turn up again. But, after a prolonged decline and a fourth move down, Gann advised watching for a bottom to form and a change in trend.
Figure 4-1: Note the clearly defined, three-section decline in the above stock chart for Anglogold, from November 1999 through January 2001.
Different Time Frames
For daily trading or short-swing trading, Gann advised never buying or selling a stock until it has halted for two to three days at the bottom or top, which will show that buying or selling is strong enough to check the advance or decline. He advised buying or selling and placing a stop-loss order not more than three points above or below the extreme high or low point at which the stock halted.
This rule, however, should not be applied in panics. On the days of extreme fluctuations and large volume, it is not necessary to wait two or three days, because the market will have a sharp reverse move up or down. Therefore, Gann advised taking profits on the days of a fast advance and, when there are big, panicky declines, to cover shorts and wait to see what the market does the following days. He urged traders to judge each stock according to its position and not to expect it to follow the movement of its own group unless its graph shows that it is in position to do so.
Gann’s time rule for judging the overall position of weekly charts involves waiting for a reaction of two to three weeks and then to buy. This applies to active stocks, as most of the active stocks will not react more than three to four weeks before the main trend is resumed. When in a bear market, reverse this rule; sell on rallies of two to three weeks. Gann instructed to always watch for a change in trend in the third week, up or down.
Gann’s weekly rule for rapid advances and rapid declines is to watch for a culmination in the sixth or seventh week, up or down; then buy or sell after watching the daily high and low chart for the week that the stock reaches top or bottom, then place a stop loss order above or below the resistance level.
His monthly time rule was based on the supposition that stocks that are in a strong position and show a pronounced upward trend will seldom ever react into the second month. His rule was to buy and place a stop-loss order under the previous month’s low level. Always watch the point at which advances start, whether from the lowest bottom or first, second, third, or fourth higher bottoms. These starting points are always buying points with a protective stop three points underneath. When a stock declines or advances after making top or bottom and the movement runs into the second month, the next important time to watch for a change in trend is the third or fourth month, according to Gann.
All of these rules work best in the stocks that are very active and are fluctuating on large volume of sales. Gann encouraged traders to study daily, weekly, and monthly high and low charts of the active high-priced stocks in order to learn how well his rules work.
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Apart from studying price movements along different time frames, Gann also advised paying close attention to specific hours, days, and months of the year in order to determine potential turning points in stocks. He observed that important changes in price often take place on Monday in the first hour of trade. “If a stock opens low on Monday and does not sell lower by 12 o’clock, it is a good sign,” he said. The next important day of the week to watch for a change in trend, according to Gann, is Wednesday, especially Wednesday afternoon.
Gann also taught that it is very important to watch how stocks act during the first few days of the month. Important changes often occur between the first and third of each month, he noted. “One reason for this is that customers always receive their statements on the first of each month and know just how their accounts stand. They often sell out to secure profits or sell out because their accounts have been weakened by declines.” The 10th of the month was also important for a change in trend for Gann. The 15th is also important but not as much as the 10th, he said. The 20th to 23rd is an important time to watch for a change in trend as well, since high or low prices are often reached around this time of the month.
“My experience has proven that the above dates are important and of value to any trader who will watch them, and will many times help in determining top or bottom,” wrote Gann.
Gann also advised watching for annual and seasonal changes in stocks. “It is important to study past movements of stocks to see how much time is usually required to complete a movement,” he wrote. “There are several sections to a major movement or swing. There are yearly and seasonal changes in all stocks, and you must watch for these seasonal changes. It is also important to watch for changes in trend every third, sixth, ninth and 12th month, but the most important time to watch for a major change in trend is at the end of each year. By this, I do not mean the calendar year. For example, if a stock makes bottom in the month of August, and the trend continues up; then the most important date would be the following August or one year later, when you should watch for at least a change in the minor trend, which might last one to three months or more.
Figure 4-2: Notice the seasonal tendency for the Dow Jones Industrial Average to decline into autumn, then reverse in the October-November time frame.
In this chapter, we have outlined how chart reading can be adapted to accurately predict and successfully trade during a wide variety of market conditions. Equally important in Gann’s work was correctly identifying periods of accumulation and distribution. He said that, “The big profits are made in the runs between accumulation and distribution.” In the next chapter, we will take a more complete look at the methods Gann used to recognize important patterns of accumulation and distribution that could help determine your next trading move.
By Cliff Droke, author, Gann Simplified
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