Dow Jones Theory, Elliot Wave Theory

Dow Jones Theory

Dow Theory (Dow Jones Theory) is a trading approach developed by Charles Dow.

Dow Theory is the basis of technical analysis of financial markets. The basic idea of Dow Theory is that market price action reflects all available information and the market price movement is comprised of three main trends.

The Averages Discount Everything.

Every knowable factor that may possibly affect both demand and supply is reflected in the market price.

The Market Has Three Trends.

According to Dow an uptrend is consistently rising peaks and troughs. And a downtrend is consistently rising lowering peaks and troughs.

Dow believed that laws of action and reaction apply to the markets just as they do to the physical universe, meaning that each significant movement is followed by a certain pullback.

Dow considered a trend to have three parts:

  1. Primary (compared to tide, reaching further and further inland until the ultimate point is reached).

  2. Secondary (compared to waves and representing corrections in the primary trend, normally retracing between one-third and two-thirds of the previous trend movement and most frequently about half of the previous move)

  3. Minor (ripples) (fluctuations in the secondary trend).

Major Trends Have Three Phases.

Dow mainly paid attention to the primary (major) trends in which he distinguished three phases:

  • Accumulation phase: The most astute investors are entering the market feeling the change in the current market direction.

  • Public participation phase: A majority of technicians begin to join in as the price is rapidly advancing.

  • Distribution phase: A new direction is now commonly recognized and well hiked; economic news are all confirming which all ends up in increasing speculative volume and wide public’s participation.

The Averages Must Confirm Each Other.

Dow used to say that unless both Industrial and Rail Averages exceed a previous peak, there is no confirmation of inception or continuation of a bull market. Signals did no have to occur simultaneously, but the quicker one followed another – the stronger the confirmation was.

Volume Must Confirm the Trend. 

Volume increases or diminishes according to whether the price is moving in direction of a trend or in reverse. Dow considered volume a secondary indicator. His buy or sell signals were based on closing prices.

A Trend Is Assumed to Be Contiunous Until Definite Signals of Its Reversal.

The overall technical approach in market analysis is based upon the idea that trends continue in motion until there is an external force causing it to change its direction – just like any other physical objects. And of course there are reversal signals to be looking for.

Elliot Wave Theory

The Elliott Wave Theory was developed by Ralph Nelson Elliott to describe price movements in financial markets, in which he observed and identified recurring, fractal wave patterns.

How Elliott Waves Work

The Elliott Wave principle consists of impulse and corrective waves at its core:

  • Impulse Waves: Impulse waves consist of five sub-waves that make net movement in the same direction as the trend of the next-largest degree.

  • Corrective Waves: Corrective waves consist of three, or a combination of three, sub-waves that make net movement in the direction opposite to the trend of the next-largest degree.

These impulse and corrective waves are nested in a self-similar fractal to create larger patterns. For example, a one-year chart may be in the midst of a corrective wave, but a 30-day chart may show a developing impulse wave. A trader with this Elliott wave interpretation might therefore have a long-term bearish outlook with a short-term bullish outlook.

Elliott recognized that the Fibonacci sequence denotes the number of waves in impulses and corrections. Wave relationships in price and time also commonly exhibit Fibonacci ratios, such as ~38% and 62%. 

Other analysts have developed indicators inspired by the Elliott Wave principle, including the Elliott Wave Oscillator, which is pictured in the image above. The oscillator provides a computerized method of predicting future price direction based on the difference between a five-period and 34-period moving average. Elliott Wave International’s artificial intelligence system, EWAVES, applies all Elliott wave rules and guidelines to data to generate automated Elliott wave analysis.

Wave rules and guidelines

A correct Elliott wave count must observe three rules:

  • Wave 2 never retraces more than 100% of wave 1.
  • Wave 3 cannot be the shortest of the three impulse waves, namely waves 1, 3 and 5.
  • Wave 4 never enters the price territory of wave 1

Five wave patterns (dominant trend)

Three wave pattern (corrective trend)

Wave 1: Wave one is rarely obvious at its inception. When the first wave of a new bull market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.

Wave A: Corrections are typically harder to identify than impulse moves. In wave A of a bear market, the fundamental news is usually still positive. Most analysts see the drop as a correction in a still-active bull market. Some technical indicators that accompany wave A include increased volume, rising implied volatility in the options markets and possibly a turn higher in open interest in related futures markets.

Wave 2: Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and “the crowd” haughtily reminds all that the bear market is still deeply ensconced. Still, some positive signs appear for those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace more than 61.8% of the wave one gains, and prices should fall in a three wave pattern.

Wave B: Prices reverse higher, which many see as a resumption of the now long-gone bull market. Those familiar with classical technical analysis may see the peak as the right shoulder of a head and shoulders reversal pattern. The volume during wave B should be lower than in wave A. By this point, fundamentals are probably no longer improving, but they most likely have not yet turned negative.

Wave 3: Wave three is usually the largest and most powerful wave in a trend (although some research suggests that in commodity markets, wave five is the largest). The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, corrections are short-lived and shallow. Anyone looking to “get in on a pullback” will likely miss the boat. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three’s midpoint, “the crowd” will often join the new bullish trend. Wave three often extends wave one by a ratio of 1.618:1.

Wave C: Prices move impulsively lower in five waves. Volume picks up, and by the third leg of wave C, almost everyone realizes that a bear market is firmly entrenched. Wave C is typically at least as large as wave A and often extends to 1.618 times wave A or beyond.

Wave 4: Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three (see Fibonacci relationships below). Volume is well below that of wave three. This is a good place to buy a pullback if you understand the potential ahead for wave 5. Still, fourth waves are often frustrating because of their lack of progress in the larger trend.

   

Wave 5: Wave five is the final leg in the direction of the dominant trend. The news is almost universally positive and everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the top. Volume is often lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high but the indicators do not reach a new peak). At the end of a major bull market, bears may very well be ridiculed (recall how forecasts for a top in the stock market during 2000 were received).

   

Elliott Wave Theory Applied to Markets

In real-time markets, it was observed that a motive wave could comprise three waves instead of five. In fact, most of the time, the market will see a motive wave that is composed of three waves. It is also possible that the market keeps moving in corrective waves. Therefore, three-wave trends are more common than five-wave trends.

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