Trading Theories

Dow Theory is a theory on stock price movements that provides a basis for technical analysis. The theory was derived from 255 Wall Street Journal editorials written by Charles H. Dow (1851-1902), journalist, founder and first editor of the Wall Street Journal and co-founder of Dow Jones and Company. (1)

Six basic tenets of Dow Theory

1. Markets have three trends
A) Up Trend
B) Down Trend
C) Original Direction Trend

2. Trends have three phases
A) Accumulation Phase
B) Rapid Price Change Phase
C) Sales Phase

3. The stock market discounts all news
Since pre-release and rumors often drive stock prices, once news is released stock prices change in sync with newly released information.

On this point, Dow Theory agrees with one of the premises of the efficient market hypothesis.(1)

4. Stock market averages must confirm each other
The theory is that a bull market is precipitated by positive daily performance of an index - specifically of the Dow Jones Transportation Index which is comprised of shipping companies, air freight carriers and major railroads.

5. Trends are confirmed by volume
Dow believed that volume confirmed price trends. (1) If only a few people are buying/selling and the volume reflects this then no trend is developing. If many people are buying/selling then volume increases and signals the development of a trend.

6. Trends exist until definitive signals prove that they have ended
Dow believed that trends existed despite "market noise" markets might temporarily move in the direction opposite the trend, but they will soon resume the prior move. (1)

*(1) Source: Dow Theory

Elliots Wave was named after Ralph Nelson Elliot who lived from 1871 to 1948 and was an accountant. Ralph Elliot developed this concept in the 1930 by suggesting that stock market prices follow specific patterns which we today call "Elliots Wave". In 1939, Financial World magazine ran a series of articles about this phenomenon. Many critics of Elliots wave say that the theory is unprovable and may be inconsistent with an efficient market hypothesis.

The principal behind Elliots wave is that investors tend to practice what is commonly called 'crowd mentality (or psychology)', which forces moves from pessimism to optimism and then back to pessimism. Since these swings then create price patterns in a stock.

Elliott's model says that market prices alternate between five waves and three waves at all degrees of trend. Basically Elliotts Wave Charts will show five waves, where the odd numbered waves represent motive and the even numbered waves show a correction. Each of these waves are then subdivided. In a bear market (downward trend), stock prices should decline while in a bull market (upward trend) stock prices should increase depending on the 'motive waves'. Motive waves are said to always move with the market trend (bear or bull) while the corrective waves are always moving in the opposite direction. Practitioners use symbols for each wave to indicate both function and degree-numbers for motive waves, letters for corrective waves. Degrees are relative; they are defined by form, not by absolute size or duration. Waves of the same degree may be of very different size and/or duration.

The classification of a wave at any particular degree can vary, though practitioners generally agree on the standard order of degrees (approximate durations given):

* Grand supercycle: multi-decade to multi-century

* Supercycle: a few years to a few decades

* Cycle: one year to a few years

* Primary: a few months to a couple of years

* Intermediate: weeks to months

* Minor: weeks

* Minute: days

* Minuette: hours

* Subminuette: minutes

Those who analyze Elliott Waves believe that you can determine what a stock will do just by reviewing the wave pattern and that you need not verify it through the stocks price chart.

Description of Wave Patterns

(note that these assume a 'bull' (upwards moving) market in stock prices and would be opposite for a 'bear' (downward moving) market.

Five Wave Pattern: The Dominant Trend

Wave 1: News on this stock will typically be negative and analysts may continue to revise earning estimates. This wave typically is seend when the economy looks to be losing strength and the overall market term is 'bearish' (i.e. more people think the market will decline than rise). Even though stock volume might increase and the price of the stock may rise slightly it will be a small enough move not to alert most analysts, making this wave less obvious at the start.

Wave 2: News on the stock remains negative and prices may fall to the stocks lowest price. Because the majority of the traders are still bearish (believe the stock will decrease further in price), there may be some positive signs for the stock which may be detected by those who are looking for positive signs. Wave 2 generally is a correction of wave one and usually will not extend beyond the starting point of wave 1.

Wave 3: Wave 3 is where you can expect to see the most powerful movement. News of this stock is now all positive and the analysts are beginning to lean towards raising earnings estimates for the stock. Prices will rise quickly and any downward price changes will change quickly. Many traders will try to get in on the 'low price' and will miss them because they're so brief. At the beginning of the third wave, some news may still be negative and some traders will continue to avoid the stock, but by mid-point in the wave, 'the crowd' will often get on board and begin purchasing the stock.

Wave 4: Typically during a Wave 4 progression, the stock doesn't move very much in price at all. Wave 4 retraces less than 40% of wave 3 and volume for the stock is significantly below that of wave 3 trading. While this might be a good place to purchase the stock, you must understand what is going to happen during wave 5 and unfortunately wave 4 features make them difficult to count.

Wave 5: The final leg of this trend is almost always positive and all of the analysts are 'bullish' (believing the stock is going to rise). Too often investors may buy stock at this level and this is usually at the highest price the stock is going to trade. The volume of trading typically is lower and other indicators (such as the stock reaching a new high price) mean that the end of the increase is at an end.

The Three Wave Corrective Trend

Wave A: During Wave A, like with Wave 1, the wave is harder to identify. The stock generally is still getting positive news, and any drop may seem to be merely a correction of pricing in an active bull (upwards moving) market. Some things that may be seen are increased volume in the stock and the options market may be priced higher, especially for options that are future priced.

Wave B: Often seen as an indicator that the bull market (increasing prices) the stock volume is now decreasing from what was seen during Wave A, and the basics of the stock are no longer improving but they're not getting any worse either.

Wave C: Suddenly the volume is increasing and traders are beginning to realize that prices are on a decline. Wave C is usually as large as Wave A and sometimes extends beyond Wave A.

Benoit Mandelbrot PhD, best known as the "father of fractal geometry" has questioned whether Elliott waves can predict financial markets:

"But Wave prediction is a very uncertain business. It is an art to which the subjective judgment of the chartists matters more than the objective, replicable verdict of the numbers. The record of this, as of most technical analysis, is at best mixed."