11/8/2017 Square Root Theory

SQUARE ROOT THEORY

References to the Square Root Theory as a predictor of stock prices pops up every now and then in financial writings. Norman
Fosback used the theory in a 1976 publication called Stock Market Logic to make the case that the normal trading range of low
price stocks provides greater profit opportunities than the normal trading range of high price stocks. In 1983, a book entitled The
Templeton Touch, by William Proctor, disclosed that one of Templeton's 22 principles for stock market investing was that stock
price fluctuations are proportional to the square root of the price.

In the 1950s William Dunnigan developed two stock trading systems called the Thrust Method and the One Way Formula. Both
methods had several advantageous entry techniques but each lacked an effective exit technique. Dunnigan was above all a
portfolio manager and not happy with the risk-reward aspects of his own trading methods, Dunnigan supported and publicized
the Square Root Theory. He went so far as to call this theory the "golden key" and claimed recognition from some economics
and statistical trade journals of the era.

WHAT IS THE SQUARE ROOT THEORY?

The theory holds that stock and other publicly traded instrument prices move over the long and short term in a square root
relationship to prior highs and lows. For example, IBM made a monthly closing low of 4.52 in June, 1962 and monthly closing
high of 125.69 in July, 1999. This is within a few percentage points of the square of the sum of the square root of the low price +
9 or (2.12+9)^2. GM made a low of 15 in November, 1974 and a high of 95 in May, 1999. Again, a few percentage points from
the square of the sum of the square root of the low + 6 or (3.87+6)^2. There are hundreds of these examples across the stock,
financial and commodity markets. Even a few minutes with a pile of stock charts and a calculator will build confidence that major
highs and lows are related to each other by additions and subtractions to their square roots.

SQUARE ROOT THEORY IN ACTION

Lets go through a recent daily chart of the SP500 and see how it works. The SP500 made a pivot low at 1060.72 on Aug-13-
2004. Is there a square root relationship to that low that may be predictive of a future pivot high? Are other high and low pivots
related by square roots?

Let's do the math. You can refer to the tutorial on constructing a Roadmap Chart in Excel for more detail.

Aug-13-2004 low = 1060.72 = Square Root 32.568

32.568 + 2.5 = 35.068
35.068 ^2 = 1229.81 = Mar-7-2005 high!
Mar-7-2005 high = 1229.11 = Square Root 35.058
35.058 - 1.25 = 33.808
33.808 ^2 = 1143.03 = Apr-20-2005 low!
Apr-20-2005 low = 1136.15 = Square Root 33.706
33.706 + 1.25 = 35.207
35.207 ^2 = 1239.52 = Jul-29-2005 high!
Jul-29-2005 high = 1245.04 = Square Root 35.285
35.285 - 1 = 34.285
34.285 ^2 = 1175.46 = Oct-13-2005 low!

How did we know to use 1 or 1.25 or 2.5 to add or subtract from the pivot points? Gann said that 90 degrees is very important for the
markets. Gann also said that the number 2 represents a full circle or 360 degrees. 1 therefore equals 180 degrees and .500 and 250 90
degrees and 45 degrees respectively. We only had to add or subtract a few increments of .500 or .250 to each pivot point to obtain these
results. Longer swings or high priced indexes may require 3, 4, 5 or even higher base addends or subtrands.

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11/8/2017 Square Root Theory
Before Dunnigan and Templeton, probably starting in the early 1900s, W.D. Gann was using square roots as an integral part of
his method to forecast stock and commodities prices and times. His method was more complex than what you see here. It
appears to have been based on some ideas Gann picked up during his trips to India or Egypt. Gann used an ennegram, a
diagram of numbers constructed in such a way to show square and square root relationships. This ennegram is whats come to
be known as the Square of Nine from the Greek root enneas which is the word for nine.

Although Gann never revealed exactly how he used the ennegram we can gather from his words that it was probably very
important to him: "We use the square of odd and even numbers to get not only the proof of market movements, but the cause."
W. D. Gann, "The Basis of My Forecasting Method" (the Geometrical Angles course), p. 1

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