by Helmut Schmidhofer
No less an authority than Charles Dow promulgated around the turn of the previous century that markets are like oceans where major moves have superimposed on them secondary moves like local storms or calms, which in turn are subject to tertiary or minor waves that continually lap up on beaches.
Dow Theory asserts that major market trends are composed of three phases: an accumulation phase, a public participation phase, and a distribution phase. The accumulation phase (phase 1) is when investors "in the know" are actively buying (selling) stock against the general opinion of the market. During this phase, the stock price does not change much because these investors are in the minority absorbing (releasing) stock that the market at large is supplying (demanding). Eventually, the market catches on to these astute investors and a rapid price change occurs (phase 2). This is when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs. At this point, the astute investors begin to distribute their holdings to the market (phase 3). (Wikipedia)
Ralph Nelson Elliott developed the Elliott Wave Theory in the late 1920s by discovering that markets traded in repetitive cycles.
An impulse wave, which sets the main trend, always shows five waves in its pattern (0-1-2-3-4-5). Within each upleg (0-1, 2-3, 4-5) five waves can again be found (i-ii-iii-iv-v). Counter waves (1-2, 3-4) comprise only three legs (a-b-c). The same pattern repeats itself in ever smaller waves ad infinitum, see day trading. The phenomenen was much later (1975) recognized by scientists to be a fractal.
Cycle theory holds that prices vacillate about some general trendline in a predictable and rythmic manner, like a sine wave on an oscilloscope.
One could say that trading with SCHM bands is based on cycle theory.
Representations of cycle boundaries run from from simply drawn tangent lines along the lows and highs of a trading range or trend, to second-order partial differential equations.
Wave theories are the most realistic ways to represent price movements. Buyers and sellers are constantly pushing and pulling prices across what is at the time their true level.
Cycle theory has less risk because you go long when the price is likely to be below the true level, and short when the price is above the true level. However, cycle theory is not risk-free.
In a trending market, it is advisable to trade only with the trend, never against it. Another risk is that a sudden and unexpected development can cause a major shift in "true level".
Professional traders don't rely on just one indicator. The most powerful and least understood indicator is volume action, which is discussed next.
Back to day trading Proceed to Volume Action
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