Gann Theory provides helpful strategies for stock and ETF traders. Here, Gann is used to break down a sector index and analyze its component stocks. We'll look at the U.S. housing market, not only to demonstrate the technique but to perhaps gain some insight into a possible recovery. Gann Theory includes a number of trading concepts above and beyond the familiar Gann angles. One of the lesser-known methods applies to why one market goes down and another goes up. When faced with such a strategy, stock traders should immediately relate this to pairs trading, and today, thanks to the exchange-traded funds (ETF) market, we can devise even more creative ways to apply this idea.

This particular discussion in Gann Theory goes on to describe a trading strategy that selects a sector that is relatively strong, and then a stock inside that sector that is relatively strong. Now, here is where the techniques come into play. Using Gann angles, retracement zones and a trend indicator chart, we can find ways to exploit the inner-strength concept that W.D. Gann proposed.

Gann's basic premise was to buy the stocks in a strong position and sell the ones in a weak position. He urged the trader to observe price charts of the individual stocks of interest, as well as the charts of sectors that contained those stocks. Gann also noted that sectors and stocks must be studied to determine their relation to an index of all stocks. This is the basic top-down analysis technique.

THE HOME MARKET

To demonstrate this strategy in the context of Gann analysis, we can start with the Dow Jones U.S. Home Builders Index. This index demonstrates how and when the trend turned based on the main trend indicator and Gann angles. It also shows how the index and stocks moved in the same direction using the main trend indicator and Gann angles.

In addition, because this market has trended down for so long and has now become one of the most important economic indicators for the U.S. economy, this analysis suggests when the trend may turn, signaling the start of either a retracement of the downtrend or the start of another rally.

The first step is to gather information on the index - in this case, the Dow Jones U.S. Home Builders Index. (Another option for this study would be the S&P Home Builders ETF (XHB), but the data do not start until July 2006, a year after the top of the housing market.) Then construct monthly, weekly and daily charts to determine the trend and trading style of this market. Examine the component stocks, and come to an understanding of which ones have been performing strongly and which ones have been performing weakly.

The Dow Jones U.S. Home Builders Index includes several stocks. To isolate the strongest and weakest individual homebuilders stocks, let's focus on the top holdings. As of Feb. 28, 2008, the top homebuilder stocks that were part of the index were:

Pulte Homes Inc. (PHM)

Hovnanian Enterprises Inc. (HOV)

Lennar Corp. (LEN)

Kb Home (KBH)

Toll Brothers Inc. (TOL)

Beazer Homes USA Inc. (BZH)

Centex Corp. (CTX)

Meritage Home Corp. (MTH)

At this point, we need to review monthly, weekly and daily charts of all the relevant stocks, applying a trend indicator, price indicators and time indicators. A Gann main trend indicator is a good place to start, especially when used in conjunction with Gann angles. Knowing the retracement zones of the various ranges that are created on the charts is also important. Finally, studying important time periods such as cycles, seasonals and anniversary dates can help you assess the strengths and weaknesses of the stocks. Studying time also helps you know whether the tendency of a stock is to lead or lag the index.

A stock's leading or lagging tendency can be found by studying time periods of tops and bottoms, then comparing them to an index or other individual stocks. Trying to pinpoint which stocks are weakest or strongest is best done with Gann angles.

Simply stated, the angles on the monthly and weekly charts are more important than those on the daily chart. The major changes in trend tend to begin on those stocks, while the daily chart may change trend several times within the main trend. Using this method, we assess strength or weakness by the position of the stock in relation to the Gann angles drawn from major tops and bottoms. The further away from the starting point of the angle, the more important the change in trend. This can occur when crossing an up- trending angle from a bottom or a down-trending angle from a top.

In this case, we are trying to determine the weakest or the strongest stock in the group. A stock is considered weak when it has completed distribution and broken under a 45-degree angle from a major bottom on the weekly or monthly chart. It also can be considered to be in its weakest position when it has fallen below 50% of a major range. Generally speaking, weakness can be shown when a market breaks key retracement points, but breaking Gann angles reveals even more information.