Technical Analysis: Dow Theory, Elliott Wave Theory, and Chart Analysis
In this lesson, we will delve into two major theories that form the bedrock of technical analysis: Dow Theory and Elliott Wave Theory.
In this lesson, we will delve into two major theories that form the bedrock of technical analysis: Dow Theory and Elliott Wave Theory.
Dow Theory: Identifying Market Trends
The first practical application of the Dow Theory involves understanding upward and downward trends:
- Upward Trend – This is a continuous series of peaks and troughs, each higher than the one before.
- Downward Trend – This is a continuous series of peaks and troughs, each lower than the preceding one.
The idea is that one can easily define a trend and identify a trend change. For instance, in an upward trend, a change in trend is signaled by a peak lower than the previous peak and a trough lower than the previous trough.
Dow proposed that for a trend to be valid, both the industrial and transportation stock indices should move in the same direction. Back then, these were the only two indices, so if they moved in the same direction, it was a strong indication of the trend's direction. Nowadays, it might be more effective to analyze, for example, the S&P 500 against the NASDAQ index.
Another essential point of Dow's theory was that trend analysis should go hand-in-hand with volume analysis. It provides a comprehensive picture when you analyze the trend graph along with the trading volume. The chart shows by how much the price has risen, while trading volume reveals the strength of the rise/fall.
Elliott Wave Theory: Understanding Market Cycles
Elliott expanded on Dow's wave theory. He observed market cycles, whether primary, secondary, or intraday. Each cycle of rise and fall comprises eight waves, which include impulse waves and corrective waves (refer to Chart A).
- Impulse Wave – These are waves in the direction of the primary trend for that period.
- Corrective Wave – These are waves against the primary trend for that period.
For instance, an upward trend consists of five waves, three impulse (upward) and two corrective (downward). A downward trend consists of three waves, two impulse (downward), and one corrective (upward).
Knowing this theory and counting the waves helps us identify where we stand in the market cycle. If we just finished a downtrend, we know we've ended a cycle, and a period of rise is due. The wave count applies to each time period, and every movement consists of a series of smaller movements (refer to Chart B).
Caveats with the Theory
However, it's not always perfect. There are many exceptions that Elliott himself identified and described. For instance, in an upward trend, one wave may be longer than the other two, increasing the wave count to 8. Specialized software today can help analyze these waves.
Another issue is where to start counting. In some cases, like when there's a historical extreme low point, it's less problematic. But there are unclear situations, like in a double bottom scenario, where instead of starting the count from the first bottom, we start from the second.
Chart A:
Chart B:
The Fibonacci Series
This is a mathematical series where each number is the sum of the two numbers that precede it. The proportions between the numbers reflect both the geometry of nature and the geometry of human thinking. If we take a number and divide it by the number after it, we get approximately 0.618, sometimes more, sometimes less. If we divide a number by the one before it, we get 1.618, sometimes more, sometimes less. This pattern is evident in various structures, such as the Acropolis. Eliot theorized that if people think in this way, it is likely that it also applies to the stock market.
All the numbers that divide the market according to Eliot's model are numbers from the Fibonacci series. The wave count is also divided according to the Fibonacci numbers. This is a very important tool in technical analysis.
Gann's Theory
Another theory is Gann's theory, which will not be taught in this lesson.
Dow, Eliot, Fibonacci, and Gann are the four theories that provide a framework for market behavior.
Chart Analysis
We will learn to analyze charts in two dimensions. One is a wide general view of the market down to daily resolution. The second aspect is learning different types of charts, from simple to more complex.
The first chart is a line chart:
The X-axis represents time. The Y-axis represents price. (Refer to chart C)
Chart C is a chart of weekly closing prices. There are also daily charts.
Chart C:
A line chart connects closing prices in the time units that I choose. The choice of time units depends on the expected investment duration, short range – daily closing prices. Long range – weekly closing prices.
Another thing to decide is whether you want the scale to be logarithmic or linear.
Linear scale – gives equal distance for every price change. The distance between 25 to 30 is the same as the distance between 30 to 35, and between 35 to 40. The problem is that the change between 25 to 30 is a 25% change, and between 50 to 55 is a 10% change.
Logarithmic scale – displays the change in percentages. An identical percentage change gets an identical distance on the chart. So the higher prices seem closer together, and the lower prices are farther apart.
Trend Line
The first tool we will use to analyze charts, in addition to Dow theory and Elliott wave theory, is called a Trend Line.
An upward trend line is a line that connects the low points of an upward trend (see Chart D).
A downward trend line connects the peak points of a downward trend (see Chart E).
Chart D:
Chart E:
A trend line provides an indication of the pace at which the trend is continuing. The coordinate system is time (X) and price (Y).
"Trend is your Friend" – the assumption is that as long as a trend continues, the basic assumption is that the likelihood that the markets will continue to move in the same direction and at the same pace is higher than a change in the trend, due to psychological reasons, etc.
A breakout of the trend line means that something in the balance of power between buyers and sellers has changed in pace, in the balance of power. If it's an upward trend line that's broken, a breakout of a trend line is a Sell Signal. Of course, we need to learn what a reliable breakout is, and what a false breakout is. We need to learn how to draw a reliable trend line and how to identify a reliable breakout.
