A fundamental requirement for all traders is to know at least the basics of technical analysis - if anything, in order to discern clear trends, up or down.

The Trend Is YOUR Friend

Your ability to spot clear trends, up or down as well as in virtually any world market will make the difference for you and will decide whether you fail or succeed in the field of e-trading. Thus, before making any trades, you should at least learn about the fundamentals of trend analysis.

Depending on your own personal investment perspectives, it is possible to use technical analysis on almost any time scale---from monthly, to weekly, to intraday and even hourly.

Good traders slowly learn how to look for diverging and repetitive patterns which will eventually guide them to investment success. In brief, there are two basic tools for evaluating future performance of almost everything---from shares, to precious metals, to currencies and almost all other trading "universes"---fundamental as well as technical analysis.

In the stock market, for example, world communications networks are so efficient today that almost all good "fundamental" information is generally late because it has already been acted upon. Building up long term holdings in particular shares is a special art which demands a considerable amount of time, establishing "inside" contacts, relying on untold amounts of analysts' reports and so forth.

E-Traders are generally not "long term" holders of positions and the present research tools (charts which represent trends, volume, open interest, etc.) are more than adequate to do the job. The old adage of "if in doubt---stay out!" should always prevail and if there is no clearly defined trend (either way-up or down) then there is no reason to rush into and take an ill-conceived investment position.

Kerford provides its clients with access to the latest state-of-the-art technology which will result in a better understanding of how markets function. For those investors who wish to further broaden their present horizons, we submit below, a brief summary of some of the most important investment theories.

The Basic Theories

Dow Theory

The Dow Theory is one the oldest technical trading concepts based upon the performance of the 30 share Dow Jones Industrial Average. The concept is essentially that the market is in a basic upward trend if one of these averages advances above a previous important high, accompanied or followed by a similar advance in the other. When both averages dip below previous important lows, this is regarded as confirmation of a downward trend.

The Dow Jones Index itself is just one type of market index which implies that the prices within it will fully reflect all existing information. Knowledge available to participants (traders, analysts, portfolio managers, market strategists and investors) is already discounted in the price action. Movements caused by unpredictable events such as "acts of god" will be contained within the overall trend. Developed primarily around stock market averages, the Dow Theory holds that prices tend to progress into wave patterns which tend to consist of three basic types of magnitude--primary, secondary and minor. The time frames involved range from less than three weeks to over a year. The theory also identified retracement patterns, which are common levels by which trends pare their moves. Such retracements are 33%, 50% and 66%.

Fibonacci Retracement

The popular retracement series is entirely based on the mathematical ratios. It is used for determining how far a price rebounded from its underlying trend.

Thousands of years ago, mathematicians discovered that a certain number kept appearing throughout the natural world. It was the ratio describing how flower petals grew around their central stem, how a snail's shell swirled around its origin and how a galaxy extended from its core. More importantly for the financial community, this ratio described how consecutive numbers related to each other. This "golden ratio" of 0.618 was applied to numbers by the thirteenth century mathematician Leonardo Fibonacci.

The Fibonacci sequence starts like this: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144. where any number in the sequence is equal to the sum of the preceding two numbers. The ratio of any two consecutive numbers starts out by oscillating around 0.618 and approaches it exactly as the sequence continues.

Actually, Fibonacci numbers are really one aspect of trading with Elliot Waves and Gann Angles. As we know, markets trend up and down, pause to retrace (consolidate, correct) then continue onward. These retracements often reclaim constant percentages of the original trend's move and can be predicted with good accuracy by the Fibonacci sequence. The ratios of consecutive numbers at the start of the sequence are 1.00, .50 and .67. Market technicians have long known that market retracements tend to end at the 50% level as well as at one and two thirds. A retracement of 100% of the move provides a very strong support/resistance line. All of these are Fibonacci levels. The one and two thirds levels are really approximations of the Fibonacci ratio 61.8% and it's inverse. Fibonacci levels are simply refined versions of what traders have been using for years.

Fibonacci retracement levels are really simple tools yet they are effective on their own. Applying them to Elliot and Gann makes them much more powerful. Elliot wave counts tend to end at Fibonacci levels. Gann angles are drawn with slopes that equal Fibonacci ratios. The most Fibonacci retracement levels are 38.2%, 50%and 61.8%.

Elliot Wave Theory

Ralph Nelson Elliott, developed the Elliott Wave principle in the late 1920s by discovering that stock markets, thought to behave in a somewhat chaotic manner, in fact, did not. They did, however, trade in what he called repetitive cycles, which he discovered were the emotions of investors as a cause of outside influences, or predominant psychology of the masses at the time. He had stated that the upward and downward swings of the mass psychology always showed up in the same repetitive patterns, which were then divided into patterns he termed Waves.

The Theory is somewhat based upon the Dow Theory in as much as the price movements also move in waves. It was understood by the technicians at the time that because of the fractal nature of the markets, Elliot was able to breakdown and analyse the markets in much greater detail. This allowed him to spot unique characteristics of wave patterns and making detailed market predictions based on the patterns he had identified. Fractals are mathematical structures, which on an ever-smaller scale infinitely repeat themselves. The patterns that Elliott discovered are built in the same way. An impulsive wave, which goes with the main trend, always shows five waves in its pattern. On a smaller scale, within each of the impulsive waves of the before mentioned impulse, again five waves will be found. Price actions are divided into trends, and corrections, or sideways movements. Trends show the main direction of prices, while corrections move against the trend. Elliot labeled these Impulsive waves and Corrective waves.

It is difficult to describe such theories in a language which most traders might be able to more easily comprehend. For example, the interpretation of the Elliot Wave Theory 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. The underlying 5-3 pattern remains constant, though the time span of each may vary. Let's have a look at the following chart made up of eight waves (five up and three down) which are labelled 1, 2, 3, 4, 5, a, b, and c.

 Elliot Wave Theory 1

You can see that the three waves in the direction of the trend are impulses and therefore these waves also have five waves. The waves against the trend are corrections and are composed of three waves.

 Elliot Wave Theory 2

In the 70s, the Wave Principle gained popularity through the work of Frost and Prechter. They published a legendary book on the Elliott Wave, entitled The Elliott Wave Principle - The Key to Stock Market Profits. In this book, the authors predicted the bull market of the 1970s both Robert Prechter called the crash of 1987.

 Elliot Wave Theory 3

The corrective wave formation normally has three, in some cases five or more distinct price movements, two in the direction of the main correction ( A and C) and one against it (B). Wave 2 and 4 in the above picture are corrections. These waves have the following structure:

 Elliot Wave Theory 4

Note that, these waves A and C go in the direction of the shorter term trend, and therefore are impulsive and composed of five waves, which is shown in the picture above.

An impulse wave formation followed by a corrective wave, form an Elliott wave degree, consisting of trend and counter trend. Although the patterns pictured above are bullish, the same applies for bear markets, where the main trend is down. The Elliott Wave theory has assigned a series of categories to the waves in order of the largest to the smallest. They are:

  • Grand Super cycle
  • Super cycle
  • Cycle
  • Primary
  • Intermediate
  • Minor
  • Minute
  • Minuette
  • Sub-Minuette

To use the theory is everyday trading, the trader will determine the Main Wave or Super cycle, and then goes long and then sells the position or shorts the position as the pattern runs out of steam and a reversal is eminent. It was impossible to develop a Real Time chart with our Trade station system to show you an accurate layout of the Theory, as the system does not support the Theory in its software program.