An early developer of technical analysis and trading was W.D. Gann. He postulated that in a perfect market, a stock price would move at a 45-degree angle either up or down on the stock chart. The 45-degree line indicated the price of the stock is moving at a rate that balances with the progression of time. A steeper angle means the stock is advancing too fast. A flatter angle means it is not showing enough market strength and will likely decline.
Retracements occur when selling pressure comes into the market and the stock price declines. This is also called a correction because it brings the overbought stock back down to a reasonable price level as traders take profits. Gann theory expects a normal retracement of 50 percent. This means that under normal selling pressure, the stock price will decline half the amount of its most recent rise. If selling pressure is light and the stock might trade up, the retracement will be 37.5 percent. If the stock is in a full correction, the retracement will be 62.5 percent of the original run-up in price from previous support. Retracement levels combined with Gann Angles give the trader an idea of when these actions are likely to take place.
To draw Gann Angles, find the important top or resistance level on the stock price chart. Draw angles at 82.5, 75, 71.25, 63.75, 45, 26.25, 18.75, 15, and 7.5 degrees from the point marking the top price traded. Drawing these angled lines in the direction of future trading creates a Gann Fan. As the market trades, price data are listed on the chart. If a market retracement comes in contact with one of the Gann Angle lines, a theoretical support has been identified. This doesn't always work, but it does supply a hint regarding whether you should be active in the market or sitting on the sidelines. For example, where the stock's 37.5 percent retracement level, as indicated by a horizontal line drawn across the chart, intersects one of the Gann lines, you should be watchful for indications of breaking down through that support level or bouncing off it and trading higher.
Traders use these intersections to discover potential support during a price retracement. If the stock price bounces off support at that point, look for resistance where the price movement encounters another Gann line above. When a Gann line is penetrated in either a retracement or a run-up in price, the next Gann line provides a potential support or resistance point. These Gann fan lines act as either potential support or resistance, depending on the level and direction of the market relative to the line.
Application to Trading
When a stock price is advancing on the chart at greater than a 45-degree angle, it is likely to correct back to find support at that 45-degree line on the Gann Fan. The 45-degree angle is considered an important support point, and a 50 percent retracement intersecting the 45-degree angle is considered powerful support. Again, these technical trading levels are not always reliable, but they do provide good indications of when to consider a market directional change possible, allowing you to prepare your strategy in case it happens.
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