| The Foundations of Gann Theory
The Basics: Pattern, Price and Time
The three basic concerns of Gann theory are pattern, price and time. By "pattern" Gann meant identifiable and recurrent price formations in charts of stocks and commodities. Gann taught that these patterns could be recognized time and again, and could be used to forecast price movements since these various patterns always tend to repeat.
Gann also placed special emphasis on "price" by which he meant that a trader should constantly focus on the price of the stock or commodity itself. Gann had several ways of doing this. He taught his students to compare the current price of a stock or commodity to its previous high or low price in order to get an indication of where it was in the trading range (a trading range is a concept that will be more fully explained in a later chapter). He also taught that a chart should be divided up into percentages from one significant bottom, placing special emphasis on the 50% portion of the divided range. Percentages were also a big part of his technique. As a student of geometry, Gann even taught that the geometric angle at which the price of a stock or commodity is positioned on a chart has meaning (another concept we'll discuss later on).
Finally, Gann emphasized "time" in the study of market. In fact, he considered the time element to be of the greatest importance, since time is the least common denominator in the equation of the marketplace and it is the only constant factor in the study of all kinds of markets. A great deal of Gann's work was centered on the study of time cycles. Seasonal trends, and historical dates. Gann gave special weighting and consideration to each of these three basic factors at different times, depending on the marketing environment in which he was trading. He believed that each of the three factors dominated at various times.
Role of Scientific Law
Gann considered the key to his success a theory he formulated based on his study of scientific laws and his observation of the laws governing the motion of bodies, which he called the "Law of Vibration". He insisted that his scientific law governed the motion the motion of everything from humans to planets, and could also be seen in the marketplace. He described his discovery of this law in detail in an interview he gave to Richard D. Wyckoff, editor of The Magazine of Wall Street, in the early 1900s. Part of that interview is excerpted below:
"I soon began to note the periodical recurrence of the rise and fall in stocks and commodities. This led me to conclude that natural law was the basis of market movements. After exhaustive researches and investigations of the known sciences, I discovered that the Law of Vibration enables me to accurately determine the exact points to which stocks or commodities should rise and fall within a given time. The working out of this law determines the cause, and predicts the effects, long before the Street is aware of either. Most speculators can testify to the fact that it is looking at the effect and ignoring the cause that has produced their losses...
"It is impossible to give an adequate idea of the Law of Vibration as I apply it to the markets; however, the layman may be able to grasp some of the principles when I state that the Law of Vibration is the fundamental law upon which wireless telegraphy, wireless telephone and phonographs are based. Without the existence of the law the above inventions would have been impossible...
"In going over the history of markets and the great mass of related statistics, it soon becomes apparent that certain laws govern the changes and variations in the value of stocks and there exists a period of cyclic law, which is at the back of all movements. Observation has shown that there are regular periods of intense activity on the Exchange followed by periods of inactivity... The law which I have applied will not only give these long cycles or swings, but the daily and even hourly movements of stocks. By knowing the exact vibration of each individual stock I am able to determine at what point each will receive support and at what point the greatest resistance is to be met...
"Those in close touch with the markets have notice the phenomena of ebb and flow, or rise and fall in the value of stocks. At certain times a stock becomes intensely active, large transactions being made in it; at other times this same stock will become practically stationary or inactive with a very small volume of sales. I have found that the Law of Vibration governs and controls these conditions. I have also found that certain phases of this law govern the rise in a stock and entirely different rules operate on the decline. I have found in the stock itself exists its harmonic or inharmonic relationship to the driving power or the force behind it... "Science teaches 'that an original impulse of any kind finally resolves itself into periodic or rhythmical motion,' also, 'just as the pendulum returns again in its swing, just as the moon returns in its orbit, just as the advancing year brings the rose to spring, so do the properties of the elements periodically recur as the weight of the atom rises...'
"From my exhaustive investigations, studies and applied tests, I find that not only do the various stocks vibrate, but that the driving forces controlling the stocks are also in the state of vibration. These vibratory forces can only be known by the movements they generate on the stocks and their values in the market. Since all great swings or movements of the market are cyclic they act in accordance with the periodic law...
"If we wish to advert failure in speculation we must deal with causes. Everything in existence is based on exact proportion and perfect relationships. There is no chance in nature, because mathematical principles of the highest order lie at the foundation of all things. Faraday said: 'There is nothing in the Universe but mathematical points of force.'...
"Through the Law of Vibration every stock in the market moves in its own distinctive sphere of activities, as to intensity, volume and direction; all the essential qualities of its evolution are characterized in its own rate of vibration. Stocks, like atoms, are really centers of energies, therefore they are controlled mathematically. Stocks create their own field of action and power; power to attract and repel, which in principle explains why certain stocks at times lead the market and 'turn dead' at other times. Thus to speculate scientifically it is absolutely necessary to follow natural laws."
Gann: The Mathematician
Gann possessed an extraordinary gift for mathematics. He was a mathematician by nature, so it only followed that much of his technical theory should be concerned with numbers and with mathematical relationships in the markets. Certain numbers took on a special significance in his work, namely, 16, 25, 36, 49, 64, 121, and 144. His numerical theory of the market was based on his study of the Bible, along with ancient Egyptian number theory.
He found for instance, that the number 7 had a special significance in the bible and thereby used it to develop a seven-day cycle theory for the short-term study of the market. He considered the number 7 to represent completeness; therefore, seven to him symbolized time and rhythm, as well as the complete cycle - the basis of Gann theory.
He also considered the half-cycle of 3 1/2 to be vitally important in his studies of the markets. The number 7 is a harmonic of 3 1/2. This number is also quite prominent in the Bible and is mentioned, among other places, as being the timeframe of Daniel's vision (3 1/2 years); the time of Christ's public ministry on earth (3 1/2 years); as well as the hiding of the Christ child in Egypt for 3 1/2 years. Thus, Gann used this to formulate a theory demonstrating the existence of a 3 1/2-day, -week, -month, and -year cycle. He applied this knowledge in trading the markets.
The number 12 also took on a special significance for Gann as it denoted for him the concept of space. Twelve is also considered to be the reference point of the cycle, since a cycle geometrically represented is a circle, which is composed of 360 degrees. Since there are 12 divisions of the circle of time (i.e., the clock), 12 months in a year, 12 houses in the zodiac, etc., the number 360 divided by 12 yields 30, a number which, besides being the number of days in a month, was important in Gann' s trading strategy. Gann posited the existence of a 30-day, 30-month and 30-year trading cycle based on the study of this number.
The number 144 (which is a product of 12 times 12) was also important for Gann, the number also representing the number of minute in a day (1441, with zero at the end being disregarded). The number 144 also recurs throughout the Bible, and therefore took on an even greater significance for him.
Based on his many years of studying number theory, then, he concluded that markets adhere to mathematical law. From this conclusion he was able to develop his trading theory. This theory basically stated that market movement is governed by the forces of pattern, price, and time.
Time: The Strongest Market Influence
According to Gann, time had the strongest influence on the market because when time is up, the trend changes. Concerning the importance Gann assigned to the time factor, consider the following Gann quote, in reference to his analysis of the October Eggs futures contract:
"The greatest time period from January 24 to February 8 was 11 market days. And the last advance from April 18 was 11 market days; therefore, when the market declines more than 11 days, it will overbalance the greatest time period. When it declines more than 75 points it will overbalance the last price declines or space reversal, and indicate lower prices."
Notice that Gann used the term "overbalance [of] time." This was a common expression of Gann's in his market writings, and forms an integral part of his theory of technical analysis. Overbalance occurs when a move in price and time over extends and travels too far in one direction. When this happens, the market can be expected to react in the opposite direction with the same force and magnitude, including the time factor. This confers a certain amount of predictability in the movements of prices once this concept has been mastered.
Combining time and price forms the basis for much of Gann theory. Author John Murphy, in Technical Analysis of the Future Markets, wrote "Gann saw a definite proportional relationship between the two. One of his methods for finding tops or bottoms is based on the squaring of price and time - that is, when a unit of price equals a unit of time. For example, Gann would take a prominent high in a market, convert that dollar figure into a calendar unit (days, weeks, months, or years), and project that time period forward. When that time period is reached, time and price are squared and a market turn due. As an illustration, if a market hit a prominent high at $100, Gann counted 100 days, weeks, months, or years forward. Those future dates identified possible turning points."
Among the timing tools Gann used is a concept he referred to as "anniversary dates." This term refers to the historical dates the market made major tops and bottoms. The information collected in effect reflects the seasonality of the market because often an anniversary date repeats in the future. A cluster of anniversary dates indicates the strong tendency of a market to post a major top and bottom each year at the same time. The dates and time spans between these anniversary dates - top to top, top to bottom, bottom to bottom, and bottom to top - were fundamental factors in his thinking. And these relationships further led to his development of theories of time cycles in his quest to accurately forecast price movements in the market.
In his book, Pattern, Price & Time, James A. Hyerczyk wrote concerning Gann's time cycle studies, "When looking at anniversary dates he saw a series of one-year cycles. In geometric terms, the one-year cycle represented a circle or 360 degrees. Building on the geometric relationship of the market, Gann also considered the quarterly divisions of the year to be important timing periods. These quarterly divisions are the 90-day cycle, the 180-day cycle, and the 270-day cycle. In using the one-year cycle and the divisions of this cycle, you will find a date where a number of these cycles line up (preferably three or more) in a single point in time in the future. A date where a number of cycles line up is called a time cluster. This time cluster is used to predict major tops and bottoms. Time cycles are a major part of Gann analysis, and should be combined with price indicators to develop a valid market forecast."
In the chapters that follow we will explain the specifics of applying Gann's methods for predicting price movements in terms of time, price, and pattern. However, one must first understand the concept of tape reading, which Gann felt was very important and this is the subject of our next chapter.