Following yesterday's 'surprise' Bank of England money-printing announcement, stocks and currencies rallied from declining trends. That brings Elliott wave analysis into sharp focus.
If you recall, I suggested that the two-month 'consolidation' phase in the Dow in August and September contained my wave 3 (9 August) and wave 4 (1 September): The Dow looks for direction as it wobbles along the tramlines.
I was then looking for the market to decline to put in a new low below the wave 3 low at 10,450 in a fifth and final wave.
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Since fifth waves are ending waves, I then expected a sharp rally to form a corrective bounce from the major decline off the all-time high at 12,920 made in May.
And this scenario has played out perfectly with a new low being put in at 10,400 last Tuesday.
Traders need to be on their toes as the fifth Elliott wave approaches
So far, so good.
The problem for trading, of course, is where will the fifth wave end? That is where short trades need to be covered and perhaps even long trades initiated.
This is one of the most difficult questions a trader faces.
And yesterday proved in spades that traders need to be nimble when the market enters fifth waves, especially in such a volatile market as the Dow.
Because the market had followed the script perfectly, many traders will be feeling great about themselves for their correct forecast and looking towards even further declines. This is normal psychological behaviour and it is wrong!
Remember, we should be getting more bullish as prices decline, and more bearish as they rise.
Why? One reason is that as prices fall, we are getting closer to the low, and vice versa.
But, since I am well aware that pride goes before a fall, that is when I was ultra-alert for signs of reversals. And we got a big one yesterday.
Thankfully, I was quick to cover my shorts, as it appeared there was to be no more downside at least for a while.
Here is the chart as of this morning:
(Click on the chart for a larger version)
I have drawn four tramlines, all of which appear convincing to me.
If you haven't seen my video tutorial on my tramline trading methods, watch it here: The essentials of tramline trading.
The market is currently challenging my upper tramline. Will it move through it? If it does, my first target will be the top tramline.
If the tramline holds, the market will move lower and through my support bar (marked in purple on chart 3, below).
Remember from previous examples, this is my favourite technique for entering trades, as it helps confirm that the resistance provided by my tramline is strong enough to hold.
This is why I say the Dow is at another crossroads.
One possible clue is provided by the FTSE action yesterday:
(Click on the chart for a larger version)
The market moved up strongly through the downtrend line, which suggests the Dow may well do likewise.
But in the FTSE chart, there was no fifth Elliott wave! Relatively, the FTSE has held up better than the Dow.
The Elliott wave count is totally different in both indexes, which means that I cannot expect 100% matching between them. But all the same, it's worth keeping an eye on them both.
The downside risk is high
Here is the close-up of the Dow as of this morning:
(Click on the chart for a larger version)
The rally off yesterday's low I can count as an A-B-C, which is corrective to the main trend, which is down.
Also, there is a stark negative momentum divergence, suggesting the rally is running out of steam.
So there is evidence for both a bullish and a bearish view as there always is, of course.
I will maintain my sell orders at the purple bar and wait.
Personally, I am not tempted to a long trade (at least, not just yet) as I believe the downside risk is too high. If the market does rally to my top tramline in the 11,400 area, I will look again at a possible short trade.
If you're a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:
The essentials of tramline trading
An introduction to Elliott wave theory
Don't miss my next trading insight. To receive all my spread betting blog posts by email, as soon as I've written them, just sign up here .
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