Dow and Elliot Wave Theory.
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Transcript of Dow and Elliot Wave Theory.
Dow Theory
Dr Saif Siddiqui
Introduction
More than 100 years old, Dow theory remains the
foundation of technical analysis.
Dow theory was formulated from a series of Wall
Street Journal editorials
Authored by Charles H. Dow, from 1900 until
the time of his death in 1902.
Introduction
These editorials reflected Dow’s beliefs on
how the stock market behaved and
how the market could be used to measure the
health of the business environment.
Due to his death, Dow never published his
complete theory on the markets,
Introduction
Some important contributions to Dow theory
William P. Hamilton's "The Stock Market
Barometer" (1922),
Robert Rhea's "The Dow Theory" (1932),
E. George Schaefer's "How I Helped More Than
10,000 Investors To Profit In Stocks" (1960)
Richard Russell's "The Dow Theory Today"
(1961).
Introduction Dow believed that
the stock market is a reliable measure of overall
business conditions
By analyzing the overall market, one could
accurately gauge those conditions
and identify the direction of major market trends
and the likely direction of individual stocks.
Introduction
Dow first used his theory to create
The Dow Jones Industrial Index and
The Dow Jones Rail Index
• now Transportation Index
which were originally compiled by Dow for The
Wall Street Journal.
Introduction
He felt that:
These indexes were an accurate reflection of the
business conditions within the economy
Because they covered two major economic
segments: industrial and rail (transportation)
Six basic tenets of Dow theory
The Market Discounts Everything
The Three-Trend Market
The Three Phases of Primary Trends
Market Indexes Must Confirm Each Other
Volume Must Confirm The Trend
Trend Remains in effect until Clear Reversal
occurs
1.The Market Discounts Everything
The first basic premise of Dow theory suggests
All information - past, current and even
future
is discounted into the markets and
reflected in the prices of stocks and indexes.
The Market Discounts Everything
That information includes everything emotions of investors , inflation interest-rate data pending earnings announcements
the only information excluded is that which is
unknowable, such as a massive earthquake.
The Market Discounts Everything
Like mainstream technical analysis, Dow theory is
mainly focused on price.
The two differ in that
Dow theory is concerned with the movements of
the broad markets
• rather than specific securities.
2.The Three-Trend Market
The market tends to move in a general direction,
or trend, it doesn't do so in a straight line.
The market will rally up to a high (peak) and then
sell off to a low (trough), but will generally move in one direction.
The Three-Trend Market
An upward trend is broken up into several rallies, where each rally has a high and a low
For a market to be considered in an uptrend,
each peak in the rally must reach a higher level than the previous rally's peak, and
each low in the rally must be higher than the previous rally's low.
An Upward trend
A downward trend A downward trend is broken up into several sell-
offs, in which each sell-off also has a high and a low.
To be considered a downtrend in Dow terms, each new low in the sell-off must be lower than
the previous sell-off's low and the peak in the sell-off must be lower then the
peak in the previous sell-off.
Downward trend
Three trends
Primary the largest trend lasting for more than a year,
Secondary an intermediate trend that lasts three weeks to three months and
Minor lasts less than three weeks
Primary Trend
In Dow theory, the primary trend is the major
trend of the market,
The primary trend will also impact the secondary
and minor trends within the market.
Primary Trend
Secondary or Intermediate Trend
A secondary trend moves
in the opposite direction of the primary trend, or
as a correction to the primary trend.
An upward primary trend will be composed of secondary downward trends.
In a primary downward trend the secondary trend will be an upward move, or a rally.
Secondary or Intermediate Trend
Minor Trend
Market movement lasting less than three weeks. The minor trend is generally the corrective
moves within a secondary move, or those moves that go against the direction of
the secondary trend.
Minor Trend
3. Three Phases of Primary Trends Primary Upward Trend (Bull Market)
The Accumulation Phase
Public Participation Phase
The Excess Phase
Primary Downward Trend (Bear Market) The Distribution Phase Public Participation Phase The Panic Phase
Primary Upward Trend
The Accumulation Phase The first stage of a bull market is referred to as
the accumulation phase, which is the start of the upward trend.
The accumulation phase typically comes at the end of a downtrend, when everything is seemingly at its worst
The Accumulation Phase
Primary Upward Trend
Public Participation Phase Informed investors entered the market during the
accumulation phase, Negative sentiment starts to dissipate as business
conditions improve As the good news starts to permeate the market,
more and more investors move back in sending prices higher.
Public Participation Phase
Primary Upward TrendThe Excess Phase The smart money starts to scale back its positions,
selling them off to those now entering the market "irrational exuberance".
The perception is that everything is running great and that only good things lie ahead.
This is the time when the last of the buyers start to enter the market
after large gains have been achieved., they are buying near the top.
The Excess Phase
Primary Downward TrendThe Distribution Phase The period in which informed buyers sell (distribute)
their positions. The informed buyers are now selling into an overbought
market It is also the phase in which there is continued buying
by the last of the investors in the market, especially those who missed the big move but are
hoping for a similar one in the near future.
Primary Downward Trend
Public Participation Phase The business conditions in the market gets worse the sentiment becomes more negative as time
goes on. The market continues to discount the worsening
conditions as selling increases and buying dries up.
Primary Downward TrendThe Panic Phase The last phase of the primary downward market tends
to be filled with market panic and can lead to very large sell-offs in a very short
period of time. In the panic phase, the market is filled up with
negative sentiment, including weak outlooks on companies, the
economy and the overall market.
4.Market Indexes Must Confirm Each Other
A major reversal from a bull to a bear market (or vice
versa) cannot be signaled unless both indexes
(traditionally the Dow Industrial and Rail Averages)
are in agreement. If one index is confirming a new primary uptrend but
another index remains in a primary downward trend, it is difficult to assume that a new trend has
begun.
5. Volume Must Confirm The Trend
In an uptrend, volume should increase when the
price rises and fall when the price falls. if volume runs counter to the trend, it is a sign
of weakness in the existing trend. If the market is in an uptrend but volume is
weak ,it is a signal that buying is starting to
dissipate.
6. Trend Remains in effect until Clear Reversal occurs
Traders wait for a clear picture of a trend reversal not to confuse a true reversal in the primary
trend with a secondary trend or brief correction. Unless you can safely conclude, based on the
weight of evidence, that the trend has changed,
you will be trading against the trend.
Current Relevance
Followers can miss out on large gains due to the
conservative nature of a trend-reversal signal. Over time, the economy - and the indexes originally
used by Dow - has changed. The industrial and transportation sectors of the
economy are not the only dominant parts.
Elliott Wave Principle
Introduction The Elliott wave principle is a form of
technical analysis attempts to forecast trends.
It is named after Ralph Nelson Elliott (1871–1948) an accountant who developed the concept in the
1930s He proposed that market prices unfold in specific
patterns, which practitioners today call Elliott waves
Critics argue
Critics argue that
the Elliott wave principle is pseudoscientific*
contradicts the efficient market hypothesis.
* Pseudoscience is defined as a body of knowledge,
belief, or practice that is claimed to be scientific,
but does not adhere to the scientific method lacks
supporting evidence
Overall design
The Wave principle posits
that collective investor psychology (or crowd
psychology) moves from optimism to
pessimism and back again.
These swings create patterns, as evidenced in
the price movements of a market
Interpretation of the Elliott Wave Theory
The is as follows: Every action is followed by a reaction. There are five waves in the direction of the
main trend followed by three corrective waves (a "5-3" move).
A 5-3 move completes a cycle. This 5-3 move then becomes two subdivisions
of the next higher 5-3 wave.
Elliott Wave
Fibonacci series
Fibonacci numbers are a series where each
succeeding number is the sum of the two
preceding numbers.
The first two Fibonacci numbers are defined to be
1, and then the series continues as follows:
1, 1, 2, 3, 5, 8, 13, 21…
As the numbers get larger, the ratio of adjacent
numbers approaches the Golden Mean: 1.618:1.
The Fibonacci Sequence – The Secret to Market Movement
In his second book Nature's Law, Elliott refined
his work to incorporate Fibonacci analysis.
Elliott believed that the wave pattern he
discovered was not the product of random chance,
but of what he considered a "natural law" that
was manifest in different facets of life.
How does this sequence relate to the market?
In the stock market, the simplest description of a
bear market is a straight line down, one wave.
The simplest description of a bull market is a
straight line up.
R.N. Elliott found that It takes one complete
bear market and one bull market to make a cycle.
How does this sequence relate to the market?
At the simplest level, that is 1 rise and 1 fall, for a total of 2 waves. The bear market subdivides into 3 waves, the bull market into 5, and the total is 8.
When you drop to the next subdivision, you find that a bear market has 13 waves, a bull market has 21, and the total is 34.
1, 1, 2, 3, 5, 8, 13, 21,34…
And so on to infinity: each new number is the sum of the previous two.
Does Elliot Wave Work? Who knows? No two practitioners seem to agree on the wave count, Robert Prechter (the most famous EW practitioner)
made several correct predictions in the 1980’s, For example, in 1985 he predicted that the market
would peak in 1987 (correct), but he thought it would peak at 3686 (± 100 points).
The DJIA actually peaked on 25 August 1987 at 2722.42, more than 960 points lower.