In the early 1900s, a trader named W.D. Gann discovered that retracements
in the securities he was trading at the time tended to occur at one-half of the
original move from the low to the high. To illustrate, say the price moved
from $10 to $30. At $30, the crowd decided that the security was overbought
and started to sell. The ensuing price decline, the retracement, stops near 50
percent of the original $10 to $30 move, namely $20. See Figure 2-2. This chart
shows the 50 percent retracement case.
In fact, Gann said that the most profitable retracement is a 50 percent
retracement. The area around 50 percent is a danger zone, because the price
can keep going and become a full-fledged reversal around there (in which
case you lose all the gains).
But it’s the best place to reenter an existing trend
(with an exit planned just below using a stop-loss order in case it doesn’t
work). If the trend resumes, Gann wrote that it will then exceed the previous
high, which gives you an automatic minimum profit target. This observation
may be the origin of the phrase, “Buy on the dip.”
Gann also saw retracements occurring at the halfway point of a move, such
as 25 percent (half of 50 percent), 12.5 percent (half of 25 percent), and so on.
Statisticians can’t offer proof that retracements occur at 12.5 percent,
25 percent, or 50 percent with more frequency than chance would allow. The
absence of statistical proof in a field populated by mathematical sophisticates
is puzzling at first.
But when you ask a statistician why he doesn’t just run the numbers and test
the hypothesis, he points out that defining the low-to-high original move and
then defining the stopping point of a retracement is a computational nightmare.
No matter what definitions he gives his software, another analyst is
sure to want to refine them in some other way. You’ll see studies, for example,
showing that the actual percentage change of many retracements isn’t
precisely 50 percent, but rather in a range of 45 to 55 percent. Should you
accept a minor retracement of 45 percent but not a major one that correctly
predicts a trend resumption at 44 percent?
A critical point about the 50 percent retracement rule is that you may think
you want to exit to protect your profit at the 50 percent level. If you bought
the security at $10 and it rose to $30, but has now fallen to $20, shown in
Figure 2-3, you want to sell at $20 to hang on to the gain you have left. But if
the 50 percent retracement rule works this time, you would be getting out
exactly when you should by buying more (adding to your position), because a
resumption of the trend at the $20 level almost certainly means that the price
will now go higher than the highest high so far, $30.
A 100 percent retracement, a price that goes from $10 to $30 and back to $10,
will often form a double bottom, a bullish formation. When the price peaks
twice at the same level, you have a double top, a bearish formation.
