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Module 3 - Making Money

 

Before commencing upon our journey it should be emphasized that the object of this series of lessons is to make money. It is not to examine the reasons why the rules work.

This is not a conversation of ‘Why's’ but an illustration of 'How's'. It is not meant to be a sophisticated dialogue with immense truths being exploded. There has been a great deal of conjecture of a magic method, which Gann discovered. We doubt whether such a magic truth exists but our methods can account for the way the markets work in all conditions and at all times.

The sole aim, early on, is to present a method which will be understandable to all, in order to make profits and reduce risks in a calm and sound environment. A selected number of Gann mathematical tools will be fused together to create a strict discipline which if followed will avoid market surprises and take advantage of market opportunities.

This is not a 'mystical' narration but a route to becoming an 'unemotional' trading machine. It is not meant to console or condemn the academic. It is anticipated that those who believe in the randomness of markets will have cause to reassess how, by some miracle rationalization, they came to the conclusion that markets are random. I find such a claim most bewildering. It is the intention of this course to prove beyond any shadow of doubt that markets are 'systematic' being strictly controlled by 'Natural Law' over the short, medium and longer term.

It will be demonstrated that certain mathematical formulae control the harmony of the markets just as they control harmony in music, physics, chemistry and indeed the universe. I am reminded of Charles Van Doren's claim that when mankind has been able to measure things, which means transform or reduce to numbers, it has indeed made great progress both in understanding and in controlling them. He ascribes the failure of Psychology, Economics, and Literary Criticism to acquire the status of science being due to their inability to reduce their opinions to simple numbers. You are about to embark on a path that will allow you to transform and reduce 'all' market movements to numbers.

It is important to untangle trading from being a hit and miss affair. Most analysis is based upon a series of marketing fairy tales. It will be self evident that the market analysis as described in these lessons can be elevated to a pure science excluding any emotional or judgmental input. Is this possible? Provided the student drops all other forms of analysis it certainly is. By dealing with each constituent of the method in a logical and unemotional manner it is not beyond any investor to completely transform his performance from bad to good or from good to brilliant!

Our story starts in the 1st Century when an autocratic mathematician, called Pythagoras, hit the world with a mathematical wisdom which has excited the world ever since. He is bestowed with the invention of the mathematical idea known in music as 'the music of spheres'. Being a great lover of music Pythagoras is said to have been playing with a musical instrument when he noted that harmonies were created by simple relationships between pairs of numbers. They were 1 to 2, 2 to 3 and 3 to 4. In today's terms they are 1/2, 2/3 and 3/4. We will be observing this relationship to market moves to great effect later. The division of eighths and thirds in music i.e. 'do-ray-me-far-so-la-tee-do' and 'dominant thirds' will also later determine our strategies and subsequent actions. Similar discoveries have been ascribed to Pythagoras determining the truth of the natural world around us by mathematical calculation and precision. Centuries later the great Medieval Astronomer, Copernicus, attributed the 'Copernicus System' to Pythagoras thus bringing the Solar System within the compass of Pythagoras mathematical relationships. Newton and Einstein expanded such ideas to extend understanding to show that all forms of nature are interminably intertwined with mathematical formulae.

However investors, economists, academics and professionals find it extraordinarily difficult to come to terms with the fact that Man himself when acting en masse is also controlled by these same Natural Laws. They argue that Man’s rationality cannot be so controlled? I say Bah! My own observations suggest that men act in markets in a most irrational way and it is this irrationality which can be measured. My experience suggests that the commencement and ending of Mass Hysteria is calculable to an extraordinary degree of exactitude.

If you find this difficult to swallow then join the masses. After all, successful traders need a large number of losers in order that they can make their extraordinary profits.

At this juncture I would ask you to approach these lessons with an open mind. Like myself, when first confronted by the truth of the markets you will probably be highly sceptical. If you are new to W.D. Gann's genius then you are certainly going to be surprised and probably amazed how the great man’s discoveries determine turning points for all the worlds investment vehicles. There are no exceptions for this is a study of 'Natural Law.' Furthermore, you don't have to be a rocket scientist to understand and profit from them.

THE PROOF


The method is designed to ban the emotional aspects of trading and investment. It is the intention to convert trading into a science rather than an art. Whilst science generally deals with ‘things’ we will be dealing with price and time. At times it will be necessary to deal with the inner state of mind and learn techniques to ultimately exclude emotion from trading in order to dispel destructive traits of opinion and prejudice.

To continue this train of thought it is necessary to include Gann's Money Management rules. Following these rules religiously will clear away many of the emotional problems of determining how much to invest, how many investments to hold and when to get rid of them should things go wrong. Oh Yes! Things will go wrong but you will know the precise day that they do. You will then be able to take action to correct the situation and perhaps reverse a small loss into a profitable reverse trade.

In many instances the first move is the most difficult of all. This will involve a temporary elimination of previous and current beliefs. For the time being at least, empty your head of any preconceived ideas and opinions. This will enable both the experienced and novice trader to follow a logical path, without interruption from other forms of analysis, which may fog the road upon which we are travelling. When the journey is over other ideas can be incorporated although we have found the comprehensive techniques we follow should be independent of any other input.

THE PUZZLE

The course will incorporate a series of tests which can be likened to a puzzle. Any individual test will be of little value although it may be an important part of the puzzle. Any single analysis, when isolated, could prove to be a weak part of a particular investment. The test should be, what sort of picture do 'all' the pieces create. The question is then do the pictures created result in a profitable performance after a reasonable period of time?

All the knowledge we can impart is valueless unless it is used to an advantage. Such a profound knowledge of 'Natural Law' requires belief, patience and dedication. Self-belief which is born out of self-study and self-investigation is critical. A practical knowledge, requiring action mostly in extreme circumstances, cannot be borrowed but has to be earned. In other words we can only help those who wish to help themselves. Failure to follow proven rules is the major weakness of most investors whether experienced or unskilled. You must be your own man and realize that generally speaking the 'experts' are usually self proclaimed with very few having accumulated fortunes by trading their own capital.

Consequently there will be time spent referring to emotional considerations where they could deflect the trader from following a particular rule efficiently and effectively without temperamental deflections.

The importance of such reference is rarely appreciated by the novice but will be recognized by all experienced traders.

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WHERE TO START?

The chart under is a copy of an original Gann drawn chart that even to this day I find difficult to interpret. To be an effective Gann trader there is no need to be so complicated. There is a far easier and direct method by using simpler techniques to obtain buying and selling levels. Perhaps they are not as superbly effective as the great man's more sophisticated techniques but they allow mere ordinary mortals to become profitable trading machines.

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Actual Gann Chart

After all would you start mathematical studies by taking on Calculus before learning your Multiplication Tables? I think not.

So where do we start?

This is a simple Gann Management chart of IBM as prepared by the writer, which shows two horizontal levels. We will be referring to these levels or bands as 'Decision' levels or 'Decision' bands. As the name implies these levels are future prices where decisions will be made. When the levels are hit the movement of the market itself, on hitting the level, will determine what action to take i.e. Buy, Short, Sell or perhaps do nothing! The decision time is not the time to have opinions but to let the market itself dictate what action you should take. Bear in mind that when Markets, Shares etc make important changes in trend it is always a time of high stress. The majority opinion will be for the trend to continue either up, up and away or down, down and under. Despite such contradictions this will be the time to act decisively and without fear and buck the general view. To do this why not let the market decide for you? When fully Gann trained you will know, days, weeks or even months in advance, the levels where the Market, Share, Currency, Commodity etc will probably bottom or top out. Only the Market really knows and in the vast majority of instances it will be obliging enough to let you know! By the application of that most important of human traits, patience, and observation of short-term moves at decision levels you will be invited to take the correct market position without any judgmental effort on your part. The rules will highlight the time and day to take action and make it a simple affair to pull the trigger. The same applications apply when profits are to be taken.

The calculated levels are not meant to predict but are purely future levels, which, if reached, will provide a level and time of decision.

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The chart for IBM now incorporates 'Gann Angles', which are based upon the passage of time as it is related to the passage of price. Gann called this 'SQUARING TIME & PRICE'. Such angles deal with the second consideration.... 'Time'. These angles will allow an assessment whether the 'Time' to buy or sell has been reached. The position of both the 'Time' and 'Price' decision levels will vary in accordance with your trading stance i.e. short-term trading, medium or long term investment.

There are three basic concepts that will be studied in this course. They are: -

1 - THE TREND
2 - THE PRICE
3 - TIME

1 - SAFETY IN THE TREND

Gann formulated a number of ways of determining the trend. Charts using these formulae are known as Swing Charts or as we shall call them 1, 2 or 3 day/week or monthly charts.

All the charts are constructed in the same way. The only difference in the construction of each is whether you are using a daily, weekly or monthly chart and whether you use a 1,2 or 3 count etc.

Gann in his teachings to the less experienced always emphasized the importance of trading with the trend and this was his first consideration.

There are two ways to use these trend charts. Firstly, they can provide an indication of risk and secondly can also be used as a tool in the decision process.


1(a) RULES OF CONSTRUCTION

For illustration purposes we will now generate a 'Two Week Chart'.

Generating a Two Week Chart

(Use a bar chart of weekly highs and lows)

Rule 1 - When the chart makes 2 consecutive weeks of higher tops and higher bottoms the chart moves up to the top of the two week moves and continues to rise until rule 2 is triggered.

('Higher Price' definition - When the highest price of the last week exceeds the highest price of the previous week AND the lowest price of the last week is higher than the lowest price of the previous week)

Rule 2 - When the chart makes 2 consecutive weeks of lower bottoms, but not necessarily lower tops, the chart moves to the lowest price.

('Lower Price' definition) - When the lowest price of one week is lower than the lowest price of the previous week)

Note 1 - Lower tops are not required to trigger rule 2. This takes into account the fact that markets generally fall faster from tops than they rise from bottoms.

Note 2 - The horizontal section of the tops and bottoms of the charts are of equal value and do not take into account time. They are purely there to indicate the top and bottoms of the two-week movements.

Note 3 - As time is not monitored the two-week chart usually lags the day by day chart.

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Generating other charts

There are various swing charts that provide different types of signals. All the charts are constructed the same way, the only differences being the time periods involved and the type of chart used.

For example

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A 'Two Day' requires a two-day period before the trend changes and is constructed on a chart based upon daily highs and lows. A 'Two month' chart requires a two-month period before the trend changes constructed on a long-term chart etc.

TREND INDICATOR LINES (ONE DAY REVERSAL CHARTS)

Trend lines are used to confirm breaks of support and resistance levels by establishing the first immediate change of trend below or above decision areas.

The short-term trend is established by reference to the trend indicator line (Til).

The construction of the Til is to simply take the line to the top of the 'spread of the day' on any day where a higher top and higher bottom is formed higher than the previous day’s high and low. On any day where a lower top and bottom or just a lower bottom is formed the trend line is taken down to the low of the day.

A 'Within' day - Where the spread for the day is within the spread of the previous day then the line remains where it was on the previous day. That is, if was at the top of the previous day it remains at the top of the 'Within' day. If it was at the bottom of the previous day then it remains at the bottom of the 'Within' day.

An 'Outside’ Day - Where the spread for the day is higher AND lower than the previous day then the line is drawn as follows.

(a) - If the price on the day falls and rises during the day then the line is drawn down to the bottom of the day and then drawn vertically up to the high of the day.

(b) - If the price on the day rises and then falls during the day then the line is drawn to the top of the day and then is drawn vertically down to the bottom of the day. (Our computer charts do not strictly follow rule (b) but compromise by following rule (a) only)

2 - USING THE TREND CHARTS.

The Rules are simple.

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The trend is UP when the last top on the chart is broken on the upside and continues to be positive until the last low on the chart is broken on the downside.

The trend is DOWN when the last bottom on the chart is broken on the downside. The trend continues down until the last top on the chart is broken on the upside.

One of the least explained of all investment techniques is what exactly is meant by a 'break'. We define a 'break' as the Trend Indicator Line confirming the break as shown under. We do not consider the price falling under the level as necessarily a break, A break is only confirmed when the Trend Indicator Line confirms that the 'trend' is established above or below the last high or low.

We have seen some Gann services that are based purely on these charts. Whilst this is a simplistic way of approaching and understanding Gann it is a highly dangerous way of trading or investing. Using this Gann technique alone fails to anticipate future problems and fails to assist in highly volatile markets or tight trading ranges. Dire results are unavoidable in the event of unexpected moves in volatile trading conditions. In such circumstances large losses are inevitably accompanied by the collapse in the trader’s confidence, possibly resulting in severe personal trauma.

It should be understood that these charts are just one piece of a jigsaw puzzle providing only a small part of the whole picture. It is often the most unimportant of Gann's techniques. We find the charts are useful for establishing the trend and a final confirmation of a signal, after all other issues fall into place. They are also effective as exit points (stop losses) in certain circumstances.

Afterthought - If a profitable short-term trade taken out against the trend is followed by a trend reversal on the two-week chart then the short-term trade could be converted into a longer-term investment.

A practical application

OUR APPROACH TO USING TREND CHARTS


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THE TWO MONTH TREND CHART (AMERICAN EXPRESS)

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Our recommended approach is to first construct and study the Two Monthly chart. This will establish the long-term trend. The American Express Two Month chart discloses that this share has an established long-term Bull trend dating back to 1993. This has been confirmed throughout the 6 year period by the continual formation of higher tops and bottoms on the chart with no breaks under the previous low on the chart.

THE TWO WEEK TREND CHART (AMERICAN EXPRESS)

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This chart allows the investor to protect himself from changes in the intermediate trend. For instance the trend turned down in October 1993 until being reversed in April 1994. This would have allowed the medium term trader to direct his attention to a more worthy cause over this 6-month period. Positions could have been re-established in April 1994 with the two-week chart confirming the 'Hold' until August 1998.

It could be argued that a break of the Two Week chart occurred in October 1997 when it fell under 76.5. We previously mentioned that a simple fall under a level was not a break of that level. A lower 'Til' top has to form under the previous low of the Two Week chart.

The chart under shows that this was not the case. The drawn dotted line would have had to be formed to change the trend downwards.

At the time of writing (Feb 1999) the Weekly chart is decidedly Bearish with lower tops and low bottoms. This is not a share, as at February 1999, in which to invest. It should, for the time being, be looked upon as a short term trading vehicle, which leads us into the Daily chart.

THE TWO DAY TREND CHART (AMERICAN EXPRESS)

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This chart establishes the short-term trend. This chart warns of a change in trend in August 1998 when the low at 104.56 was broken with the downtrend continuing until it was reversed October 1998. The limited use of these Swing Charts, on their own, for trading purposes can clearly be observed on this chart. The 'Short' possibility was useful as the downtrend was signalled early but the upward trend signal was far too late for any practical application.

ASSESSING THE CHARTS TOGETHER (AMERICAN EXPRESS)


A good practical example of an overall assessment of each chart simultaneously would have been in October 1998 when the short-term trend moved up but was countered by the bearish nature of the Two-Week chart thus negating the Bullish Daily chart.

Similarly the Two Week chart downturn in October 1998 would have been negated by the Bullish Two Month chart for the longer-term investor who would still hold the share today. Again it could be argued that the Two Month chart broke to the downside in September and October of 1998 having fallen under the lows of October 1997 suggesting that the longer-term investor should have sold. The chart under shows that the Trend Indicator Line (Til) did not confirm the break.

THE ONE DAY TREND CHART (TREND INDICATOR LINE)


The Trend Indicator Line (Til) is the first indicator for a change in trend and is used to trigger Buy and Sell signals.

Our recent 'Buy' recommendation of Chase Manhattan Bank on this Web Site is a good example of the Til in action.

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We had isolated an important decision level at 40. When the share collapsed to the 40 level all we then needed was the final confirmation of the opportunity. This signal would be confirmed by the formation of a higher Til bottom as follows :-

1 - As can be seen on the chart under, this share bottomed out at 35.56 on the 8th October 1998.

2 - It then rallied to 45.25 on the 12th October 1998.

3 - This was followed by a correction down to 40.68 on the 14th October 1998.

4 - The share then rose on the 15th October 1998 to 48.62 signalling the Buy as the Til had formed a higher Til bottom.

This then is how we use the various Trend Indictors.


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This Guide to Gann comes courtesy of Gann Management Ltd www.gann.co.uk