Fan Principle Definition
The fan principle basically states that the breaking of the third trendline signals the reversal of a trend. It is a very important trend to be aware of when doing trend analysis. The fan principle can be applied to the bottom of a market, where the breaking of the third trendline signals the upside trend reversal as shown in the image below.
The trend of a market is the tendency of financial markets to move in a particular direction over time. All technical analysis, such as Fibonacci Retracements, Elliot Wave Theory, and head and shoulders patterns are attempts to determine the trend of a market so that one can participate in that trend. There is a real art to properly draw a trendline and sometimes a trendline that looks correct may have to be redrawn.
I first learned about this technique in John J. Murphy‘s foundational text, “Technical Analysis of the Financial Markets“.
The following photos are taken from his text (pages 74-76):
Figure 4.11a – Example of the fan principle. The breaking of the third trendline signals the reversal of a trend. Notice also that the broken trendlines 1 and 2 often become resistance.
The conclusion that Murphy draws is that breaking of the third trend line is a Valid major trend reversal sign, ie. if breaking a downward trend then, “buying the breakout” above the 3rd trend line that has just been broken. As with breakage of any trend line, it is always good to have price and/or time filters (ie. close above for minimum two days or close 3% above limit price)
The Fan Principle Applied to Bitcoin
Below, I first applied the technique to the 2014 Bitcoin correction (obviously, I did it in retrospect which is always easier than real time). As you can see, it worked out almost perfectly.
And finally, the goods you have all been waiting for… I then applied the technique to the current 2018 correction that is underway.